UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended May 31, 2007
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ___________
Commission file number 1-8989
The Bear Stearns Companies Inc.
(Exact name of registrant as specified in its charter)
Delaware 13-3286161
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
383 Madison Avenue, New York, New York 10179
(Address of Principal Executive Offices) (Zip Code)
(212) 272-2000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer" and "large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large Accelerated Filer [X] Accelerated Filer [ ] Non-Accelerated Filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of July 6, 2007, the latest practicable date, there were 116,124,098
shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
-----------------
Page
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Available Information 3
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS (UNAUDITED)
Condensed Consolidated Statements of Income for
the three months and six months ended May 31, 2007
and May 31, 2006 4
Condensed Consolidated Statements of Financial Condition
as of May 31, 2007 and November 30, 2006 5
Condensed Consolidated Statements of Cash Flows
for the six months ended May 31, 2007 and May 31, 2006 6
Notes to Condensed Consolidated Financial Statements 7
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 34
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Introduction 35
Certain Factors Affecting Results of Operations 35
Forward-Looking Statements 36
Executive Overview 36
Results of Operations 39
Liquidity and Capital Resources 45
Off-Balance-Sheet Arrangements 55
Derivative Financial Instruments 55
Critical Accounting Policies 56
Accounting and Reporting Developments 59
Effects of Inflation 60
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 61
Item 4. CONTROLS AND PROCEDURES 65
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS 66
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 67
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 68
Item 6 EXHIBITS 70
Signature 71
2
AVAILABLE INFORMATION
The Bear Stearns Companies Inc. and its subsidiaries ("Company") files current,
annual and quarterly reports, proxy statements and other information required by
the Securities Exchange Act of 1934, as amended ("Exchange Act"), with the
Securities and Exchange Commission ("SEC"). You may read and copy any document
the Company files at the SEC's public reference room located at 100 F Street,
NE, Room 1580, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for
further information on the public reference room. The Company's SEC filings are
also available to the public from the SEC's internet site at http://www.sec.gov.
Copies of these reports, proxy statements and other information can also be
inspected at the offices of the New York Stock Exchange, Inc., 20 Broad Street,
New York, New York 10005.
The Company's public internet site is http://www.bearstearns.com. The Company
makes available free of charge through its internet site, via a link to the
SEC's internet site at http://www.sec.gov, its annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements
and Forms 3, 4 and 5 filed on behalf of directors and executive officers and any
amendments to those reports filed or furnished pursuant to the Exchange Act, as
soon as reasonably practicable after it electronically files such material with,
or furnishes it to, the SEC.
In addition, the Company currently makes available on http://www.bearstearns.com
its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q
for the current fiscal year and its most recent proxy statement, although in
some cases these documents are not available on that site as soon as they are
available on the SEC's internet site. Also posted on the Company's website, and
available in print upon request of any stockholder to the Investor Relations
Department, are charters for the Company's Audit Committee, Compensation
Committee, Corporate Governance Committee, Nominating Committee and Qualified
Legal Compliance Committee. Copies of the Corporate Governance Guidelines and
the Code of Business Conduct and Ethics governing our directors, officers and
employees are also posted on the Company's website within the "Corporate
Governance" section under the heading "About Bear Stearns." You will need to
have the Adobe Acrobat Reader software on your computer to view these documents,
which are in the .PDF format.
3
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited) (Unaudited)
Three Months Ended Six Months Ended
---------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands, except share and per share data) 2007 2006 2007 2006
----------------------------------------------------------------------------------------------------------------
REVENUES
Commissions $ 305,654 $ 305,251 $ 586,299 $ 591,322
Principal transactions 1,222,964 1,492,478 2,565,341 2,642,910
Investment banking 404,271 318,150 754,450 656,003
Interest and dividends 2,806,103 2,110,876 5,463,296 3,834,865
Asset management and other income 236,810 76,994 404,155 217,067
---------------------------------------------------------------
Total revenues 4,975,802 4,303,749 9,773,541 7,942,167
Interest expense 2,463,826 1,804,307 4,779,793 3,257,522
---------------------------------------------------------------
Revenues, net of interest expense 2,511,976 2,499,442 4,993,748 4,684,645
---------------------------------------------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 1,231,403 1,220,216 2,435,497 2,267,066
Floor brokerage, exchange and clearance fees 63,907 58,621 119,992 109,864
Communications and technology 142,850 118,169 270,758 222,203
Occupancy 63,870 45,422 120,615 90,049
Advertising and market development 48,756 35,093 85,829 69,766
Professional fees 89,297 65,468 161,163 119,341
Impairment of goodwill and specialist rights 227,457 - 227,457 -
Other expenses 90,779 122,254 183,574 219,804
---------------------------------------------------------------
Total non-interest expenses 1,958,319 1,665,243 3,604,885 3,098,093
---------------------------------------------------------------
Income before provision for income taxes 553,657 834,199 1,388,863 1,586,552
Provision for income taxes 191,933 294,866 473,398 533,063
---------------------------------------------------------------
Net income $ 361,724 $ 539,333 $ 915,465 $ 1,053,489
Preferred stock dividends 5,257 5,376 10,514 10,790
---------------------------------------------------------------
Net income applicable to common shares $ 356,467 $ 533,957 $ 904,951 $ 1,042,699
===============================================================
Basic earnings per share $ 2.78 $ 4.12 $ 7.02 $ 8.04
Diluted earnings per share $ 2.52 $ 3.72 $ 6.34 $ 7.26
===============================================================
Weighted average common shares outstanding:
Basic 131,684,419 132,810,062 132,383,898 132,778,755
Diluted 148,745,798 149,945,896 149,226,168 149,780,912
===============================================================
Cash dividends declared per common share $ 0.32 $ 0.28 $ 0.64 $ 0.56
===============================================================
See Notes to Condensed Consolidated Financial Statements.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
------------------------------------------------------------------------------------------------------
May 31, November 30,
(in thousands, except share data) 2007 2006
------------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 11,178,338 $ 4,595,184
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations 4,652,616 8,803,684
Securities received as collateral 18,948,242 19,648,241
Collateralized agreements:
Securities purchased under agreements to resell 42,271,724 38,838,279
Securities borrowed 92,049,674 80,523,355
Receivables:
Customers 41,343,821 29,481,799
Brokers, dealers and others 4,484,566 6,119,348
Interest and dividends 1,156,044 744,542
Financial instruments owned, at fair value 136,410,748 109,200,487
Financial instruments owned and pledged as
collateral, at fair value 12,264,669 15,967,964
-------------------------------------
Total financial instruments owned, at fair value 148,675,417 125,168,451
Assets of variable interest entities and mortgage
loan special purpose entities 49,985,058 30,303,275
Property, equipment and leasehold improvements,
net of accumulated depreciation and amortization
of $1,059,850 and $1,152,279 as of May 31, 2007
and November 30, 2006, respectively 547,106 479,637
Other assets 8,011,127 5,726,800
-------------------------------------
Total Assets $ 423,303,733 $ 350,432,595
=====================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Unsecured short-term borrowings $ 17,424,064 $ 25,787,454
Obligation to return securities received as collateral 18,948,242 19,648,241
Collateralized financings:
Securities sold under agreements to repurchase 103,029,370 69,749,675
Securities loaned 10,571,003 11,451,324
Other secured borrowings 9,115,110 3,275,260
Payables:
Customers 84,603,650 72,988,661
Brokers, dealers and others 3,961,976 3,396,835
Interest and dividends 1,336,669 1,123,348
Financial instruments sold, but not yet purchased,
at fair value 46,349,811 42,256,544
Liabilities of variable interest entities and
mortgage loan special purpose entities 47,923,181 29,079,552
Accrued employee compensation and benefits 1,620,159 2,895,047
Other liabilities and accrued expenses 3,322,119 2,081,354
Long-term borrowings 61,790,274 54,569,916
-------------------------------------
Total Liabilities $ 409,995,628 $ 338,303,211
=====================================
Commitments and contingencies (Note 11)
STOCKHOLDERS' EQUITY
Preferred stock 359,156 359,156
Common stock, $1.00 par value; 500,000,000 shares
authorized and 184,805,847 shares issued as of both
May 31, 2007 and November 30, 2006 184,806 184,806
Paid-in capital 4,936,888 4,578,972
Retained earnings 10,211,317 9,384,595
Employee stock compensation plans 2,701,312 2,221,997
Unearned compensation (197,202) (155,596)
Treasury stock, at cost:
Common stock: 66,643,533 and 67,396,876 shares as of May
31, 2007 and November 30, 2006, respectively (4,888,172) (4,444,546)
-------------------------------------
Total Stockholders' Equity 13,308,105 12,129,384
-------------------------------------
Total Liabilities and Stockholders' Equity $ 423,303,733 $ 350,432,595
=====================================
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Six Months Ended
---------------------------------
May 31, May 31,
(in thousands) 2007 2006
-----------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 915,465 $ 1,053,489
Adjustments to reconcile net income to cash used in
operating activities:
Non-cash items included in net income:
Impairment of goodwill and specialist rights 227,457 -
Depreciation and amortization 86,948 169,491
Deferred income taxes (5,970) (4,322)
Employee stock compensation plans 7,593 10,237
Changes in operating assets and liabilities:
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations 4,151,068 (1,919,538)
Securities borrowed, net of securities loaned (12,406,640) (11,164,496)
Receivables from customers (11,862,022) 164,106
Receivables from brokers, dealers and others 1,634,782 462,316
Financial instruments owned, at fair value (24,464,065) (18,150,812)
Other assets (3,181,191) (266,016)
Securities sold under agreements to repurchase, net of
securities purchased under agreements to resell 29,846,250 4,695,997
Payables to customers 11,614,989 3,398,020
Payables to brokers, dealers and others 565,141 460,125
Financial instruments sold, but not yet purchased, at
fair value 4,138,107 6,206,028
Accrued employee compensation and benefits (449,976) (163,596)
Other liabilities and accrued expenses 1,454,231 (113,927)
---------------------------------
Cash provided by (used in) operating activities 2,272,167 (15,162,898)
---------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (147,355) (91,541)
---------------------------------
Cash used in investing activities (147,355) (91,541)
---------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Payments for/proceeds from unsecured short-term borrowings,
net (8,363,390) 8,981,979
Proceeds from other secured borrowings, net 5,839,850 3,908,755
Proceeds from issuance of long-term borrowings 12,982,220 8,805,573
Payments for retirement/repurchase of long-term borrowings (5,383,191) (6,417,374)
Proceeds from issuances of derivatives with a financing
element, net (44,840) 242,812
Issuance of common stock 97,085 177,105
Cash retained resulting from tax deductibility under
share-based payment arrangements 220,609 300,896
Redemption of preferred stock - (5,393)
Treasury stock purchases - common stock (802,207) (529,643)
Cash dividends paid (87,794) (78,068)
---------------------------------
Cash provided by financing activities 4,458,342 15,386,642
---------------------------------
Net increase in cash and cash equivalents 6,583,154 132,203
Cash and cash equivalents, beginning of year 4,595,184 5,859,133
---------------------------------
Cash and cash equivalents, end of period $ 11,178,338 $ 5,991,336
=================================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash payments for interest were $5.15 billion and $3.46 billion during the
six months ended May 31, 2007 and 2006, respectively.
Cash payments for income taxes, net of refunds, were $443.9 million and
$325.8 million for the six months ended May 31, 2007 and 2006,
respectively. Cash payments for income taxes, net of refunds, would have
been $664.5 million and $626.7 million for the six months ended May 31,
2007 and 2006, respectively, if increases in the value of equity
instruments issued under share-based payment arrangements had not been
deductible in determining taxable income.
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
6
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
The Bear Stearns Companies Inc. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally
Bear, Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp.
("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer and operates in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets is
comprised of the institutional equities, fixed income and investment
banking areas. Global Clearing Services provides clearance-related
services for prime brokerage clients and clearance on a fully disclosed
basis for introducing broker-dealers. Wealth Management is comprised of
the private client services ("PCS") and asset management areas. See Note
13, "Segment Data," in the Notes to Condensed Consolidated Financial
Statements for a complete description of the Company's principal segments.
The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited;
Custodial Trust Company; Bear Stearns Financial Products Inc.; Bear
Stearns Capital Markets Inc.; Bear Stearns Credit Products Inc.; Bear
Stearns Forex Inc.; EMC Mortgage Corporation; Bear Stearns Commercial
Mortgage, Inc.; and Bear Hunter Holdings LLC. The Company participates,
through Bear Hunter Holdings LLC, in specialist activities on the New York
Stock Exchange ("NYSE"), American Stock Exchange ("AMEX") and
International Securities Exchange ("ISE").
Basis of Presentation
The Condensed Consolidated Financial Statements include the accounts of
the Company, its wholly owned subsidiaries and other entities in which the
Company has a controlling interest. Additionally, in accordance with
Financial Accounting Standards Board ("FASB") Interpretation ("FIN") No.
46 (R), "Consolidation of Variable Interest Entities (revised December
2003)--an interpretation of Accounting Research Bulletin ("ARB") No. 51"
("FIN No. 46 (R)"), the Company also consolidates any variable interest
entities ("VIEs") for which it is the primary beneficiary. The assets and
related liabilities of such variable interest entities have been shown in
the Condensed Consolidated Statements of Financial Condition in the
captions "Assets of variable interest entities and mortgage loan special
purpose entities" and "Liabilities of variable interest entities and
mortgage loan special purpose entities." See Note 5, "Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to
Condensed Consolidated Financial Statements.
As of December 1, 2006, the Company has fully adopted Emerging Issues Task
Force ("EITF") Issue No. 04-5 "Determining Whether a General Partner, or
the General Partners as a Group, Controls a Limited Partnership or Similar
Entity When the Limited Partners Have Certain Rights." The EITF consensus
requires a general partner in a limited partnership to consolidate the
limited partnership unless the presumption of control is overcome. The
general partner may overcome this presumption of control and not
consolidate the entity if the limited partners have: (a) the substantive
ability to dissolve or liquidate the limited partnership or otherwise
remove the general partner without having to show cause; or (b)
substantive participating rights in managing the partnership.
When the Company does not have a controlling interest in an entity, but
exerts significant influence over the entity's operating and financial
decisions (generally defined as owning a voting or economic interest of
20% to 50%), the Company applies the equity method of accounting.
The Condensed Consolidated Statement of Financial Condition as of May 31,
2007, the Condensed Consolidated Statements of Income for the three and
six months ended May 31, 2007 and 2006 and the Condensed Consolidated
Statements of Cash Flows for the six months ended May 31, 2007 and 2006
are unaudited. The Condensed Consolidated Statement of Financial Condition
at November 30, 2006 and related information were derived from the audited
consolidated financial statements included in the Company's Form 10-K.
The Condensed Consolidated Financial Statements are prepared in accordance
with the rules and regulations of the Securities and Exchange Commission
("SEC") with respect to the Form 10-Q and reflect all adjustments which,
in the opinion of management, are normal and recurring, and which are
necessary for a fair statement of the results for the interim periods
presented. In accordance with such rules and regulations, certain
disclosures that are normally included in annual financial statements have
been omitted. These Condensed Consolidated Financial Statements should be
read
7
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
together with the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2006, as filed by the Company under the Securities
Exchange Act of 1934, as amended ("Exchange Act") (the "Form 10-K").
The Condensed Consolidated Financial Statements are prepared in conformity
with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions, including those regarding inventory valuations, stock-based
compensation, certain accrued liabilities, the potential outcome of
litigation and tax matters, and mortgage servicing rights, which may
affect the amounts reported in the Condensed Consolidated Financial
Statements and accompanying notes. Actual results could differ materially
from these estimates. The nature of the Company's business is such that
the results of any interim period may not be indicative of the results to
be expected for an entire fiscal year. All material intercompany
transactions and balances have been eliminated in consolidation. Certain
prior period amounts have been reclassified to conform to the current
period's presentation.
Financial Instruments
On December 1, 2006, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 157, "Fair Value Measurements." SFAS No. 157
defines fair value, establishes a framework for measuring fair value and
requires enhanced disclosures about fair value measurements. Additionally,
SFAS No. 157 disallows the use of block discounts on positions traded in
an active market as well as nullifies certain guidance in EITF No. 02-3
regarding the recognition of inception gains on certain derivative
transactions. See Note 2, "Financial Instruments" of Notes to Condensed
Consolidated Financial Statements for a complete discussion on SFAS No.
157.
Proprietary securities, futures and other derivative transactions are
recorded on a trade date basis. Financial instruments owned and financial
instruments sold, but not yet purchased, including contractual commitments
arising pursuant to futures, forward and option contracts, interest rate
swaps and other derivative contracts, are recorded at fair value with the
resulting net unrealized gains and losses reflected in "Principal
transactions" revenues in the Condensed Consolidated Statements of Income.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, fair value is determined based on other relevant
factors, including dealer price quotations, price activity for equivalent
instruments and valuation pricing models. Valuation pricing models
consider time value, yield curve and volatility factors, prepayment
speeds, default rates, loss severity, current market and contractual
prices for the underlying financial instruments, as well as other
measurements.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the Condensed Consolidated
Financial Statements at fair value, which is often represented as initial
cost until significant transactions or developments indicate that a change
in the carrying value of the securities is appropriate. This represents
the Company's best estimate of exit price as defined by SFAS No. 157.
Generally, the carrying values of these securities will be increased based
on company performance and in those instances where market values are
readily ascertainable by reference to substantial transactions occurring
in the marketplace or quoted market prices. Reductions to the carrying
value of these securities are made when the Company's estimate of net
realizable value has declined below the carrying value.
Derivative Instruments and Hedging Activities
The Company follows SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," as amended by SFAS No. 138, "Accounting for
Certain Derivative Instruments and Certain Hedging Activities," and SFAS
No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities," which establishes accounting and reporting standards for
stand-alone derivative instruments, derivatives embedded within other
contracts or securities, and hedging activities. Accordingly, all
derivatives, whether stand-alone or embedded within other contracts or
securities (except in narrowly defined circumstances), are carried in the
Company's Condensed Consolidated Statements of Financial Condition at fair
value, with changes in fair value recorded in "Principal transactions"
revenues. Designated hedged items in fair value hedging relationships are
marked for the risk being hedged, with such changes also recorded in
"Principal transactions" revenues.
On December 1, 2006, the Company adopted SFAS No. 155, "Accounting for
Certain Hybrid Financial Instruments an amendment of FASB Statements No.
133 and 140." SFAS No. 155 permits companies to elect on
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
an instrument-by-instrument basis, to apply a fair value measurement to
hybrid financial instruments that contain an embedded derivative that
would otherwise require bifurcation under SFAS No. 133. As permitted, on
December 1, 2006, the Company elected to apply a fair value measurement to
all existing hybrid financial instruments that met the SFAS No. 155
definition. The Company also elected the fair value measurement for all
qualifying hybrid financial instruments issued on or after December 1,
2006. The Company's reason for electing to carry these instruments on a
fair value basis was to enable the Company to more efficiently hedge these
instruments and to simplify the accounting process. The hybrid instruments
are reported as a component of "Other liabilities" in the Fair Value
Measurements disclosure. The transition adjustment related to the adoption
of SFAS No. 155 did not have a material impact on the Condensed
Consolidated Financial Statements of the Company.
The Company follows FIN No. 39, "Offsetting Amounts Related to Certain
Contracts," and offsets assets and liabilities in the Condensed
Consolidated Statements of Financial Condition provided that the legal
right of offset exists under a master netting agreement. This includes the
offsetting of payables or receivables relating to the fair value of cash
collateral received or paid associated with its derivative inventory, on a
counterparty by counterparty basis.
Customer Transactions
Customer securities transactions are recorded on the Condensed
Consolidated Statements of Financial Condition on a settlement date basis,
which is generally three business days after trade date, while the related
commission revenues and expenses are recorded on a trade date basis.
Receivables from and payables to customers include amounts related to both
cash and margin transactions. Securities owned by customers, including
those that collateralize margin or other similar transactions, are
generally not reflected in the Condensed Consolidated Statements of
Financial Condition.
Mortgage Servicing Assets, Fees and Advances
Mortgage servicing rights ("MSRs") are included in "Other assets" on the
Condensed Consolidated Statements of Financial Condition. On December 1,
2006, the Company adopted SFAS No. 156, "Accounting for Servicing of
Financial Assets--an amendment of FASB Statement No. 140," and elected to
measure servicing assets at fair value. The fair value of MSRs is
determined by using market-based models that discount anticipated future
net cash flows considering loan prepayment predictions, interest rates,
default rates, servicing costs, current market data and other economic
factors.
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected in "Investment Banking"
revenues in the Condensed Consolidated Statements of Income. Contractual
servicing fees are recognized when earned based on the terms of the
servicing agreement. All other fees are recognized when received. In the
normal course of its business, the Company makes principal, interest and
other servicing advances to external investors on mortgage loans serviced
for these investors. Such advances are generally recoverable from the
mortgagors, related securitization trusts or from the proceeds received
from the sales of the underlying properties. A charge to earnings is
recognized to the extent that servicing advances are estimated to be
uncollectible under the provisions of the servicing contracts.
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a replacement of
FASB Statement No. 125," to account for securitizations and other
transfers of financial assets and collateral. SFAS No. 140 establishes
accounting and reporting standards with a financial-components approach
that focuses on control. Under this approach, financial assets or
liabilities are recognized when control is established and derecognized
when control has been surrendered or the liability has been extinguished.
Control is deemed to be relinquished only when all of the following
conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee
is a Qualifying Special Purpose Entity ("QSPE") or has the right to pledge
or exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. The Company derecognizes
financial assets transferred in securitizations provided that such
transfer meets all of these criteria.
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Mortgage securitization transactions, net of certain direct costs, are
recorded in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income.
Collateralized Securities Transactions
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income. Reverse repurchase agreements
and repurchase agreements are presented in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities with a market value in
excess of the principal amount loaned plus the accrued interest thereon,
in order to collateralize reverse repurchase agreements. Similarly, the
Company is generally required to provide securities to counterparties to
collateralize repurchase agreements. The Company's agreements with
counterparties generally contain contractual provisions allowing for
additional collateral to be obtained, or excess collateral returned. It is
the Company's policy to value collateral and to obtain additional
collateral, or to retrieve excess collateral from counterparties, when
deemed appropriate.
Securities borrowed and securities loaned are recorded based upon the
amount of cash collateral advanced or received. Securities borrowed
transactions facilitate the settlement process and require the Company to
deposit cash, letters of credit or other collateral with the lender. With
respect to securities loaned, the Company receives collateral in the form
of cash or other collateral. The amount of collateral required to be
deposited for securities borrowed, or received for securities loaned, is
an amount generally in excess of the market value of the applicable
securities borrowed or loaned. The Company monitors the market value of
securities borrowed and loaned, with excess collateral retrieved or
additional collateral obtained, when deemed appropriate.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized. Investment banking and advisory services revenues are
presented net of transaction-related expenses.
Commissions
Commission revenues primarily include fees from executing and clearing
client transactions on stock, options and futures markets worldwide. These
fees are recognized on a trade-date basis. The Company records its share
of the commission under certain commission sharing arrangements where the
Company is acting as agent for another broker, in accordance with EITF
Statement No. 99-19, "Reporting Revenue Gross as a Principal versus Net as
an Agent."
Asset Management and Other Income
The Company receives advisory fees for investment management. In addition,
the Company receives performance incentive fees for managing certain
funds. Advisory fees are recognized over the period of advisory service.
Unearned advisory fees are treated as deferred revenues and are included
in "Other liabilities" in the accompanying Condensed Consolidated
Statements of Financial Condition. Performance incentive fees are accrued
throughout the year based on a fund's performance to date against
specified performance targets.
Fixed Assets
Depreciation of property and equipment is provided by the Company on a
straight-line basis over the estimated useful life of the asset.
Amortization of leasehold improvements is provided on a straight-line
basis over the lesser of the estimated useful life of the asset or the
remaining life of the lease.
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Goodwill and Identifiable Intangible Assets
The Company accounts for goodwill and identifiable intangible assets under
the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In
accordance with this guidance, the Company does not amortize goodwill, but
amortizes identifiable intangible assets over their useful lives. Goodwill
is tested at least annually for impairment and identifiable intangible
assets are tested for potential impairment whenever events or changes in
circumstances suggest that the carrying value of an asset or asset group
may not be fully recoverable in accordance with SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets." See Note 14,
"Acquisition of Minority Interest and Impairment of Intangible Assets" of
Notes to Condensed Consolidated Financial Statements for further
discussion.
Earnings Per Share
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share." Basic EPS is computed by dividing net income
applicable to common shares, adjusted for costs related to vested shares
under the Capital Accumulation Plan for Senior Managing Directors, as
amended ("CAP Plan"), as well as the effect of the redemption of preferred
stock, by the weighted average number of common shares outstanding. Common
shares outstanding includes vested units issued under certain stock
compensation plans, which will be distributed as shares of common stock.
Diluted EPS includes the determinants of basic EPS and, in addition, gives
effect to dilutive potential common shares related to stock compensation
plans.
Stock-Based Compensation
The Company follows SFAS No. 123 (R), "Share-Based Payment," to account
for its stock-based compensation plans. SFAS No. 123 (R) is a revision of
SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows."
SFAS No. 123 (R) eliminated the ability to account for share-based
compensation transactions using APB No. 25, and requires all share-based
payments to employees, including grants of employee stock options, to be
recognized in the financial statements using a fair value-based method.
The Company adopted SFAS No. 123 (R) effective December 1, 2005, using the
modified prospective method. The Company previously elected to adopt fair
value accounting for stock-based compensation consistent with SFAS No.
123, using the prospective method with guidance provided by SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosures,"
effective December 1, 2002. As a result, commencing with options granted
after November 30, 2002, the Company expenses the fair value of stock
options issued to employees over the related vesting period.
Cash Equivalents
The Company has defined cash equivalents as liquid investments not held
for sale in the ordinary course of business with original maturities of
three months or less that are not part of the Company's trading inventory.
Income Taxes
The Company and certain of its subsidiaries file a U.S. consolidated
federal income tax return. The Company accounts for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes." Under SFAS No.
109, deferred income taxes are based on the net tax effects of temporary
differences between the financial reporting and tax bases of assets and
liabilities. In addition, deferred income taxes are determined by the
enacted tax rates and laws expected to be in effect when the related
temporary differences are expected to be reversed.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the probability for additional assessments. Once
established, reserves are adjusted as information becomes available or
when an event requiring a change to the reserve occurs.
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Translation of Foreign Currencies
Assets and liabilities denominated in foreign currencies are translated at
period end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal period. Comprehensive
income was materially the same as net income for the Company for the three
and six months ended May 31, 2007 and 2006. Gains or losses resulting from
foreign currency transactions are included in net income.
Accounting and Reporting Developments
In July 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes--an interpretation of FASB Statement No. 109"
("FIN No. 48"). FIN No. 48 clarifies the accounting for uncertainty in
income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN No. 48 prescribes a recognition
threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The Company will adopt the provisions of FIN
No. 48 beginning in the first quarter of 2008. The Company is currently
evaluating the impact, if any, the adoption of FIN No. 48 may have on the
Condensed Consolidated Financial Statements of the Company.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities." SFAS No. 159 permits entities
to elect to measure financial assets and liabilities (except for those
that are specifically scoped out of the Statement) at fair value. The
election to measure a financial asset or liability at fair value can be
made on an instrument-by-instrument basis and is irrevocable. The
difference between the carrying value and the fair value at the election
date is recorded as a transition adjustment to opening retained earnings.
Subsequent changes in fair value are recognized in earnings. The Company
will adopt SFAS No. 159 effective December 1, 2007. The Company does not
expect the adoption of SFAS No. 159 to have a material impact on the
Condensed Consolidated Financial Statements of the Company.
In April 2007, the FASB issued a Staff Position ("FSP") FIN No. 39-1,
"Amendment of FASB Interpretation No. 39." FSP FIN No. 39-1 defines "right
of setoff" and specifies what conditions must be met for a derivative
contract to qualify for this right of setoff. It also addresses the
applicability of a right of setoff to derivative instruments and clarifies
the circumstances in which it is appropriate to offset amounts recognized
for those instruments in the statement of financial position. In addition,
this FSP permits offsetting of fair value amounts recognized for multiple
derivative instruments executed with the same counterparty under a master
netting arrangement and fair value amounts recognized for the right to
reclaim cash collateral (a receivable) or the obligation to return cash
collateral (a payable) arising from the same master netting arrangement as
the derivative instruments. The provisions of this FSP are consistent with
the Company's current accounting practice. This interpretation is
effective for fiscal years beginning after November 15, 2007, with early
application permitted. The adoption of FSP FIN No. 39-1 will not have a
material impact on the Condensed Consolidated Financial Statements of the
Company.
In May 2007, the FASB issued FSP FIN No. 46(R)-7, "Application of FASB
Interpretation No. 46(R) to Investment Companies." FSP FIN No. 46(R)-7
amends the scope of the exception to FIN No. 46(R) to state that
investments accounted for at fair value in accordance with the specialized
accounting guidance in the American Institute of Certified Public
Accountants ("AICPA") Audit and Accounting Guide, Investment Companies,
are not subject to consolidation under FIN No. 46(R). This interpretation
is effective for fiscal years beginning on or after December 15, 2007.
Certain consolidated subsidiaries currently apply the accounting guidance
in the AICPA Audit and Accounting Guide, Investment Companies. The Company
is currently evaluating the impact, if any, that the adoption of this
interpretation will have on the Condensed Consolidated Financial
Statements of the Company.
In June 2007, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position ("SOP") 07-1, "Clarification of the Scope of
the Audit and Accounting Guide Investment Companies and Accounting by
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Parent Companies and Equity Method Investors for Investments in Investment
Companies." This SOP provides guidance for determining whether an entity
is within the scope of the AICPA Audit and Accounting Guide Investment
Companies (the "Guide"). Additionally, it provides guidance as to whether
a parent company or an equity method investor can apply the specialized
industry accounting principles of the Guide (referred to as investment
company accounting). This SOP is effective for fiscal years beginning on
or after December 15, 2007, with early application encouraged. The Company
is currently evaluating the impact, if any, the adoption of SOP 07-1 may
have on the Condensed Consolidated Financial Statements of the Company.
2. FINANCIAL INSTRUMENTS
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at
fair value, were as follows:
May 31, November 30,
(in thousands) 2007 2006
------------------------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED, AT FAIR VALUE:
U.S. government and agency $ 5,473,131 $ 6,136,191
Other sovereign governments 3,374,448 1,371,713
Corporate equity and convertible debt 38,369,273 28,892,588
Corporate debt and other 38,029,347 33,924,116
Mortgages, mortgage- and asset-backed 52,163,618 43,226,699
Derivative financial instruments 11,265,600 11,617,144
------------------------------------------------------------------------------------------
$ 148,675,417 $125,168,451
==========================================================================================
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED, AT FAIR VALUE:
U.S. government and agency $ 9,725,821 $ 11,724,095
Other sovereign governments 2,465,661 1,275,145
Corporate equity and convertible debt 15,844,828 12,623,291
Corporate debt and other 5,309,378 4,714,019
Mortgages, mortgage- and asset-backed 188,042 54,802
Derivative financial instruments 12,816,081 11,865,192
------------------------------------------------------------------------------------------
$ 46,349,811 $ 42,256,544
==========================================================================================
Note: Certain prior period amounts have been reclassified to conform to
the current period's presentation.
As of May 31, 2007 and November 30, 2006, all financial instruments owned
that were pledged to counterparties where the counterparty has the right,
by contract or custom, to rehypothecate those securities are classified as
"Financial instruments owned and pledged as collateral, at fair value" in
the Condensed Consolidated Statements of Financial Condition.
Financial instruments sold, but not yet purchased, at fair value,
represent obligations of the Company to purchase the specified financial
instrument at the then current market price. Accordingly, these
transactions result in off-balance-sheet risk as the Company's ultimate
obligation to repurchase such securities may exceed the amount recognized
in the Condensed Consolidated Statements of Financial Condition.
Concentration Risk
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At May 31, 2007 and November 30, 2006, the
Company's most significant concentrations were related to U.S. government
and agency inventory positions, including those of the Federal National
Mortgage Association and the Federal Home Loan Mortgage Corporation. In
addition, a substantial portion of the collateral held by the Company for
reverse repurchase agreements consists of securities issued by the U.S.
government and agencies.
13
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Fair Value Measurements
On December 1, 2006, the Company adopted SFAS No. 157, "Fair Value
Measurements." SFAS No. 157 applies to all financial instruments that are
being measured and reported on a fair value basis. This includes those
items currently reported in "Financial instruments owned, at fair value"
and "Financial instruments sold, but not yet purchased, at fair value" on
the Condensed Consolidated Statements of Financial Condition as well as
financial instruments reported in "Other assets" and "Other liabilities"
that are reported at fair value.
As defined in SFAS No. 157, fair value is the price that would be received
to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. In determining fair
value, the Company uses various methods including market, income and cost
approaches. Based on these approaches, the Company often utilizes certain
assumptions that market participants would use in pricing the asset or
liability, including assumptions about risk and or the risks inherent in
the inputs to the valuation technique. These inputs can be readily
observable, market corroborated, or generally unobservable firm inputs.
The Company utilizes valuation techniques that maximize the use of
observable inputs and minimize the use of unobservable inputs. Based on
the observability of the inputs used in the valuation techniques the
Company is required to provide the following information according to the
fair value hierarchy. The fair value hierarchy ranks the quality and
reliability of the information used to determine fair values. Financial
assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Quoted market prices in active markets for identical assets or
liabilities.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
Level 1 primarily consists of financial instruments whose value is based
on quoted market prices such as exchange-traded derivatives and listed
equities. Additionally, this category also includes those financial
instruments that are typically valued using alternative approaches but for
which the Company typically receives independent external valuation
information including U.S. Treasuries, other U.S. Government and agency
securities, as well as other sovereign debt.
Level 2 includes those financial instruments that are valued using models
or other valuation methodologies. These models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates,
loss severity, current market and contractual prices for the underlying
financial instruments, as well as other relevant economic measures.
Substantially all of these assumptions are observable in the marketplace,
can be derived from observable data or are supported by observable levels
at which transactions are executed in the marketplace. Financial
instruments in this category include certain corporate equities, corporate
debt, certain mortgage-backed securities and non-exchange-traded
derivatives such as interest rate swaps.
Level 3 is comprised of financial instruments whose fair value is
estimated based on internally developed models or methodologies utilizing
significant inputs that are generally less readily observable from
objective sources. Included in this category are distressed debt,
non-performing mortgage-related assets, certain mortgage-backed securities
and residual interests, Chapter 13 and other credit card receivables from
individuals, and complex and exotic derivative structures including
long-dated equity derivatives.
In determining the appropriate levels, the firm performs a detailed
analysis of the assets and liabilities that are subject to SFAS No. 157.
At each reporting period, all assets and liabilities for which the fair
value measurement is based on significant unobservable inputs are
classified as Level 3.
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Fair Value Measurements on a Recurring Basis as of May 31, 2007
------------------------------------------------------------------------------------------------------------
Impact of Balance as of
(in thousands) Level 1 Level 2 Level 3 Netting May 31, 2007
------------------------------------------------------------------------------------------------------------
Financial Instruments Owned, at
fair value
-------------------------------------------------------------------------------------------------------------
Non-Derivative Trading
Inventory $ 34,605,041 $ 93,268,406 $ 9,536,370 $ - $ 137,409,817
-------------------------------------------------------------------------------------------------------------
Derivative Trading Inventory 3,305,662 69,066,580 4,851,741 (65,958,383) 11,265,600
-------------------------------------------------------------------------------------------------------------
Total Financial Instruments
Owned, at fair value 37,910,703 162,334,986 14,388,111 (65,958,383) 148,675,417
-------------------------------------------------------------------------------------------------------------
Other Assets 806,290 893,201 3,626,461 - 5,325,952
-------------------------------------------------------------------------------------------------------------
Total Assets at fair value $ 38,716,993 $ 163,228,187 $ 18,014,572 $ (65,958,383) $ 154,001,369
-------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------
Impact of Balance as of
(in thousands) Level 1 Level 2 Level 3 Netting May 31, 2007
-------------------------------------------------------------------------------------------------------------
Financial Instruments Sold But
Not Yet Purchased, at fair value
-------------------------------------------------------------------------------------------------------------
Non-Derivative Trading
Inventory $ 26,230,224 $ 7,152,896 $ 150,610 $ - $ 33,533,730
-------------------------------------------------------------------------------------------------------------
Derivative Trading Inventory 3,174,092 67,384,417 5,793,969 (63,536,397) 12,816,081
-------------------------------------------------------------------------------------------------------------
Total Financial Instruments
Sold But Not Yet Purchased, at
fair value 29,404,316 74,537,313 5,944,579 (63,536,397) 46,349,811
-------------------------------------------------------------------------------------------------------------
Other Liabilities 82,130 6,851,485 2,918,142 - 9,851,757
-------------------------------------------------------------------------------------------------------------
Total Liabilities at fair value $ 29,486,446 $ 81,388,798 $ 8,862,721 $ (63,536,397) $ 56,201,568
-------------------------------------------------------------------------------------------------------------
As stated above SFAS No. 157 applies to all financial assets and
liabilities that are reported on a fair value basis. These valuations are
adjusted for various factors including credit risk. For applicable
financial assets carried at fair value, the credit standing of the
counterparties is analyzed and factored into the fair value measurement of
those assets. SFAS No. 157 states that the fair value measurement of a
liability must reflect the nonperformance risk of the entity. Therefore,
the impact of credit standing as well as any potential credit enhancements
(e.g. collateral) has been factored into the fair value measurement of
both financial assets and liabilities.
The non-derivative trading inventory category includes securities such as
U.S. Government and agency, other sovereign governments, corporate
equities, convertible debt, corporate debt, mortgages, mortgage- and
asset-backed, as well as certain other items. They are reported in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" on the Condensed Consolidated
Statements of Financial Condition. The derivatives trading inventory
balances in the table above are reported on a gross basis by level with a
netting adjustment presented separately in the "Impact of Netting" column.
The Company often enters into different types of derivative contracts with
a single counterparty and these contracts are covered under one ISDA
master netting agreement. The fair value of the individual derivative
contracts are reported gross in their respective levels based on the fair
value hierarchy.
Other assets and other liabilities represent those financial assets and
liabilities that the Company carries at fair value but are not included in
"Financial instruments owned, at fair value" and "Financial instruments
sold, but not yet purchased, at fair value" captions. Other assets
includes certain items such as alternative investments, mortgage servicing
rights, assets of VIEs and mortgage securitizations that did not meet the
criteria for sale treatment under SFAS No. 140. Other liabilities is
primarily comprised of certain hybrid debt issuances accounted for at fair
value as elected in accordance with SFAS No. 155.
During the May 2007 quarter, the Company had intangible assets that were
measured at fair value on a non-recurring basis. These intangible assets
represent goodwill and specialist rights and are categorized as Level 3
within the fair value hierarchy. The change in valuation was due to a
$227.5 million impairment charge taken during the 2007 quarter. The
Company used a present value technique in which multiple cash flow
scenarios reflecting possible outcomes and a discount rate were used to
estimate fair value at May 31, 2007. See Note 14, "Acquisition of Minority
Interest and Impairment of Intangible Assets" to the Condensed
Consolidated Financial Statements for further details on the impairment of
intangible assets.
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following tables provide a reconciliation of the beginning and ending
balances for the major classes of assets and liabilities measured at fair
value using significant unobservable inputs (Level 3):
Level 3 Financial Assets and Liabilities
Six months ended May 31, 2007
------------------------------------------------------------------------------------------------------------------------------------
Changes in
Unrealized
Gains/(Losses)
Total Gains/ relating to
Beginning (Losses) Purchases, Ending Assets and
Balance as of (Realized Issuances, Transfers Balance as Liabilities
December 1, and Sales and In/Out of of May 31, held at the
(in thousands) 2006 Unrealized) Settlements Level 3 2007 reporting date
------------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets $ 8,999,658 $ (528,756) $ 1,033,489 $ 31,979 $ 9,536,370 $ (401,400)
Non Derivative Trading Liabilities $ (190,141) $ (14,367) $ (19,570) $ 73,468 $ (150,610) $ (390)
Derivative Trading Inventory (Net) $ (2,223,112) $ (492,625) $ 1,103,105 $ 670,404 $ (942,228) $ (196,554)
Other Assets $ 2,836,060 $ 25,363 $ 545,081 $ 219,957 $ 3,626,461 $ 73,518
Other Liabilities $ (3,514,847) $ 1,283 $ 836,095 $ (240,673) $ (2,918,142) $ (13,323)
Level 3 Financial Assets and Liabilities
Three months ended May 31, 2007
------------------------------------------------------------------------------------------------------------------------------------
Changes in
Unrealized
Gains/(Losses)
Total Gains/ relating to
Beginning (Losses) Purchases, Ending Assets and
Balance as of (Realized Issuances, Transfers Balance as Liabilities
March 1, and Sales and In/Out of of May 31, held at the
(in thousands) 2007 Unrealized) Settlements Level 3 2007 reporting date
------------------------------------------------------------------------------------------------------------------------------------
Non-Derivative Trading Assets $ 11,054,785 $ (346,304) $ 24,921 $ (1,197,032) $ 9,536,370 $ (311,922)
Non Derivative Trading Liabilities $ (214,225) $ (128,415) $ 133,890 $ 58,140 $ (150,610) $ (10,197)
Derivative Trading Inventory (Net) $ (1,933,889) $ (163,761) $ 1,045,326 $ 110,096 $ (942,228) $ (49,677)
Other Assets $ 3,322,443 $ 234 $ 196,724 $ 107,060 $ 3,626,461 $ 3,376
Other Liabilities $ (2,208,342) $ (37,592) $ (105,413) $ (566,795) $ (2,918,142) $ (47,576)
Realized and unrealized gains and losses on Level 3 assets and liabilities
are primarily reported in "Principal Transactions" in the Condensed
Consolidated Statements of Income. The Company manages its exposure on a
portfolio basis and regularly engages in offsetting strategies in which
financial instruments from one fair value hierarchy level are used to
economically offset the risk of financial instruments in the same or
different levels. Therefore, realized and unrealized gains and losses
reported as Level 3 may be offset by gains or losses attributable to
assets or liabilities classified in Level 1 or Level 2.
The Company reviews the fair value hierarchy classifications on a monthly
basis. Changes in the observability of the valuation attributes may result
in a reclassification of certain financial assets or liabilities. Such
reclassifications are reported as transfers in/out of Level 3 at fair
value in the month in which the changes occur.
3. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial instruments for proprietary trading and to manage its exposure
to market and credit risk. These risks include interest rate, exchange
rate, equity price, and commodity price risk. Derivative financial
instruments represent contractual commitments between counterparties that
derive their value from changes in an underlying interest rate, currency
exchange rate, index (e.g., Standard & Poor's 500 Index), reference rate
(e.g., London Interbank Offered Rate, or LIBOR), or asset value referenced
in the related contract. Some derivatives, such as futures contracts,
certain options and index-referenced warrants, can be traded on an
exchange. Other derivatives, such as interest rate and currency swaps,
caps, floors, collars, swaptions, equity swaps and options, credit
derivatives, structured notes and
16
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. Generally, these financial instruments represent
commitments or rights to exchange interest payment streams or currencies
or to purchase or sell other securities at specific terms at specified
future dates. Option contracts generally provide the holder with the
right, but not the obligation, to purchase or sell a financial instrument
at a specific price on or before an established date or dates. Financial
instruments sold, but not yet purchased may result in market and/or credit
risk in excess of amounts recorded in the Condensed Consolidated
Statements of Financial Condition.
Market Risk
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk, whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of a
particular financial instrument in excess of the amounts currently
reflected in the Condensed Consolidated Statements of Financial Condition.
The Company's exposure to market risk is influenced by a number of
factors, including the relationships among and between financial
instruments with off-balance-sheet risk, the Company's proprietary
securities, futures and derivatives inventories as well as the volatility
and liquidity in the markets in which the financial instruments are
traded. The Company mitigates its exposure to market risk by entering into
offsetting transactions, which may include over-the-counter derivative
contracts or the purchase or sale of interest-bearing securities, equity
securities, financial futures and forward contracts. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate
market risks associated with holding dealer inventories or in connection
with arbitrage-related trading activities.
Derivatives Credit Risk
Credit risk arises from the potential inability of counterparties to
perform in accordance with the terms of the contract. At any point in
time, the Company's exposure to credit risk associated with counterparty
non-performance is generally limited to the net replacement cost of
over-the-counter contracts, net of the value of collateral held. Such
financial instruments are reported at fair value on a net-by-counterparty
basis pursuant to enforceable netting agreements. Exchange-traded
financial instruments, such as futures and options, generally do not give
rise to significant unsecured counterparty exposure due to the Company's
margin requirements, which may be greater than those prescribed by the
individual exchanges. Options written by the Company generally do not give
rise to counterparty credit risk since they obligate the Company (not its
counterparty) to perform.
The Company has controls in place to monitor credit exposures by assessing
the future creditworthiness of counterparties and limiting transactions
with specific counterparties. The Company also seeks to control credit
risk by following an established credit approval process, monitoring
credit limits and requiring collateral where appropriate.
Hedging Activity
To modify the interest rate characteristics of its long- and short-term
debt, the Company also engages in non-trading derivatives activities. The
Company has issued U.S. dollar- and foreign currency-denominated debt with
both variable- and fixed-rate interest payment obligations. The Company
has entered into interest rate swaps, primarily based on LIBOR, to convert
fixed-rate interest payments on its debt obligations into variable-rate
payments. In addition, for foreign currency debt obligations that are not
used to fund assets in the same currency, the Company has entered into
currency swap agreements that effectively convert the debt into U.S.
dollar obligations. Such transactions are accounted for as fair value
hedges.
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's
market-making and trading activities. The Company has similar controls in
place to monitor these risks. SFAS No. 133, as amended by SFAS No. 138 and
SFAS No. 149, establishes accounting and reporting standards for
stand-alone derivative instruments, derivatives embedded within other
contracts or securities and for hedging activities. It requires that all
derivatives, whether stand-alone or embedded within other contracts or
securities (except in very defined circumstances) be carried on the
Company's Condensed Consolidated Statements of Financial Condition at fair
value. SFAS No. 133 also requires items designated as being fair value
hedged to be marked to market for the risk being hedged, as defined in
SFAS No. 133, provided that the intent to hedge is fully documented. Any
resultant net change in value for the hedging derivative and the hedged
item for the risk being
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
hedged is recognized in earnings immediately, such net effect being deemed
the "ineffective" portion of the hedge. The gains and losses associated
with the ineffective portion of the fair value hedges are included in
"Principal transactions" revenues in the Condensed Consolidated Statements
of Income. These amounts were immaterial for the three and six months
ended May 31, 2007 and 2006.
On December 1, 2006, the Company adopted SFAS No. 155 and elected to apply
a fair value measurement to all existing hybrid financial instruments that
meet the SFAS No. 155 definition. The Company also elected the fair value
measurement for all qualifying hybrid financial instruments issued on or
after December 1, 2006.
4. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. Retained interests in securitizations
are generally not held to maturity and typically are sold shortly after
the settlement of a securitization. The weighted average holding period
for retained interest positions in inventory at May 31, 2007 and November
30, 2006 was approximately 160 days and 150 days, respectively. These
retained interests are included in "Financial instruments owned, at fair
value" in the Condensed Consolidated Statements of Financial Condition and
are carried at fair value. Consistent with the valuation of similar
inventory, fair value is determined by broker-dealer price quotations and
internal valuation pricing models that utilize variables such as yield
curves, prepayment speeds, default rates, loss severity, interest rate
volatilities and spreads. The assumptions used for pricing variables are
based on observable transactions in similar securities and are further
verified by external pricing sources, when available.
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company's securitization activities are detailed below:
Agency
Mortgage- Other Mortgage-
(in billions) Backed and Asset-Backed Total
--------------------------------------------------------------------------
Total securitizations
Six months ended May 31, 2007 $13.6 $46.4 $60.0
Six months ended May 31, 2006 $10.8 $49.6 $60.4
Retained interests
As of May 31, 2007 $2.4 $4.8 $7.2 (1)
As of November 30, 2006 $1.5 $4.1 $5.6 (2)
--------------------------------------------------------------------------
(1) Includes approximately $5.7 billion in investment-grade retained
interests of which $3.8 billion is AAA rated.
(2) Includes approximately $4.3 billion in investment-grade retained
interests of which $3.0 billion is AAA rated.
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the six months ended May 31,
2007 and 2006:
Agency
Mortgage- Other Mortgage-
(in millions) Backed and Asset-Backed Total
--------------------------------------------------------------------------
Cash flows received from retained
interests
Six months ended May 31, 2007 $68.3 $288.3 $356.6
Six months ended May 31, 2006 $68.3 $180.9 $249.2
Cash flows from servicing
Six months ended May 31, 2007 - $21.0 $21.0
Six months ended May 31, 2006 $ 0.1 $27.2 $27.3
--------------------------------------------------------------------------------
The Company is an active market maker in these securities and therefore
may retain interests in assets it securitizes, predominantly highly rated
or government agency-backed securities. The models employed in the
valuation of retained interests consider possible changes in prepayment
speeds in response to changes in future interest rates, as well as
potential credit losses. Prepayment speed changes are incorporated by
calibrating the distribution of possible future intest rates to the
observed levels of implied volatility in the market for interest rate
options and generating the corresponding cash flows for the securities
using prepayment models. Credit losses are considered through explicit
loss models for positions exposed to significant default risk in the
underlying collateral, and through option-adjusted spreads that also
incorporate additional factors such as liquidity and model uncertainty for
all positions. The models use discount rates that are based on the
Treasury curve, plus the option-adjusted spread. Key points on the
constant maturity Treasury curve at May 31, 2007 were 4.92% for 2-year
Treasuries and 4.96% for 10-year Treasuries, and ranged from 4.80% to
5.12%. The weighted average spread was 66 basis points and 683 basis
points for agency mortgage-backed securities and other mortgage- and
asset-backed securities, respectively, at May 31, 2007.
Key economic assumptions used in measuring the fair value of retained
interests in assets the Company securitized at May 31, 2007 were as
follows:
Agency Other Mortgage-
Mortgage-Backed and Asset-Backed
--------------------------------------------------------------------------
Weighted average life (years) 8.8 4.2
Average prepayment speeds (annual rate) 6% - 25% 8% - 55%
Credit losses - 0% - 24%
--------------------------------------------------------------------------
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following hypothetical sensitivity analysis as of May 31, 2007
illustrates the potential adverse change in fair value of these retained
interests due to a specified change in the key valuation assumptions. The
interest rate changes represent a parallel shift in the Treasury curve.
This shift considers the corresponding effect of other variables,
including prepayments. The remaining valuation assumptions are changed
independently. Retained interests in securitizations are generally not
held to maturity and are typically sold shortly after the settlement of a
securitization. The Company considers the current and expected credit
profile of the underlying collateral in determining the fair value and
periodically updates the fair value for changes in credit, interest rate,
prepayment and other pertinent market factors. Changes in portfolio
composition, updates to loss and prepayment models, and changes in the
level of interest rates and market prices for retained interests can
combine to produce significant changes in the sensitivities reported even
if aggregate market value does not change significantly. Actual credit
losses on retained interests have not been significant.
Agency Other Mortgage-
(in millions) Mortgage-Backed and Asset-Backed
--------------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (63.8) $ (36.5)
Impact of 100 basis point adverse change (129.1) (105.2)
--------------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (3.5) -
Impact of 20% adverse change (6.3) (3.4)
--------------------------------------------------------------------------
Credit losses
Impact of 10% adverse change (8.2) (61.7)
Impact of 20% adverse change (16.3) (122.1)
--------------------------------------------------------------------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of offsetting positions, which would generally offset the changes detailed
in the table, nor does it consider any corrective action that the Company
may take in response to changes in these conditions. The impact of
offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
Mortgage Servicing Rights
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In
connection with these activities, the Company may retain MSRs that entitle
the Company to a future stream of cash flows based on the contractual
servicing fee. In addition, the Company may purchase and sell MSRs.
As of December 1, 2006, the Company adopted SFAS No. 156 and elected to
carry its MSRs at fair value, with changes in fair value reported in
earnings. Prior to December 1, 2006, the Company reported the MSRs on a
lower of cost or market basis.
The determination of fair value of the Company's MSRs requires management
judgment because they are not actively traded. The determination of fair
value for MSRs requires valuation processes which combine the use of
discounted cash flow models and extensive analysis of current market data
to arrive at an estimate of fair value. The cash flow and prepayment
assumptions used in the Company's discounted cash flow model are based on
empirical data drawn from the historical performance of our MSRs, which we
believe are consistent with assumptions used by market participants
valuing similar MSRs. The key risks and therefore the key assumptions used
in the valuation of MSRs include mortgage prepayment speeds and the
discount rates. These variables can, and generally will, change from
quarter to quarter as market conditions and projected interest rates
change. The Company mitigates the income statement effect of changes in
fair value of MSRs by entering into economic offsetting transactions.
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
At May 31, 2007, the key economic assumptions and the sensitivity of the
current fair value of MSRs to immediate changes in those assumptions were
as follows:
May 31,
(in millions) 2007
----------------------------------------------------------
Fair value of MSRs $ 683.7
Weighted average constant prepayment rate (CPR) 31.3%
Impact on fair value of:
5 CPR adverse change $ (35.1)
10 CPR adverse change (67.1)
Weighted average discount rate 13.2%
Impact on fair value of:
5% adverse change $ (46.7)
10% adverse change (88.4)
----------------------------------------------------------
The above table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on adverse variations
in assumptions generally cannot be extrapolated because the relationship
of the change in assumptions to the change in fair value is not usually
linear. In addition, the table does not consider the change in fair value
of offsetting positions, which would generally offset the changes detailed
in the table, nor does it consider any corrective action that the Company
may take in response to changes in these conditions. The impact of
offsetting positions is not presented because these positions are
established on a portfolio level and allocating the impact would not be
practicable.
MSRs are included in "Other assets" on the Condensed Consolidated
Statements of Financial Condition. The Company's MSRs activities for the
six months ended May 31, 2007 was as follows:
Six months
ended
--------------------------------------------------------------------------
May 31,
(in millions) 2007
--------------------------------------------------------------------------
Balance, beginning of period $ 502.0
Additions 203.5
Paydowns (77.4)
Changes in fair value resulting from changes in
valuation inputs/assumptions 55.6
--------------------------------------------------------------------------
Balance, end of period $ 683.7
==========================================================================
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be
variable interest entities (VIEs). These entities are an essential part of
its securitization, asset management and structured finance businesses. In
addition, the Company purchases and sells financial instruments that may
be variable interests. The Company follows the guidance in FIN No. 46(R)
and consolidates those VIEs in which the Company is the primary
beneficiary.
The Company may perform various functions, including acting as the seller,
servicer, investor, structurer or underwriter in securitization
transactions. These transactions typically involve entities that are
considered to be QSPEs as defined in SFAS No. 140. QSPEs are exempt from
the requirements of FIN No. 46 (R). For securitization vehicles that do
not qualify as QSPEs, the holders of the beneficial interests have no
recourse to the Company, only to the assets held by the related VIE. In
certain of these VIEs, the Company could be determined to be the primary
beneficiary through its ownership of certain beneficial interests, and
would, therefore, be required to consolidate the assets and liabilities of
the VIE.
21
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company has a limited number of mortgage securitizations that did not
meet the criteria for sale treatment under SFAS No. 140, including
transactions where the retained call option did not meet the definition of
a clean up call under SFAS No. 140. As such, the Company continues to
carry the assets and liabilities from these transactions on its Condensed
Consolidated Statements of Financial Condition.
The Company acts as portfolio manager in several collateralized debt
obligation and collateralized loan obligation transactions. In these
transactions, the Company establishes a trust that purchases a portfolio
of assets and issues trust certificates that represent interests in the
portfolio of assets. The holders of the trust certificates have recourse
only to the underlying assets of the trusts and not to other assets of the
Company. In addition, the Company may receive variable compensation for
managing the portfolio and may also retain certain trust certificates. In
certain of these transactions, these interests result in the Company
becoming the primary beneficiary of these entities. The Company's maximum
exposure to loss on these consolidated VIEs was $143 million at May 31,
2007.
The Company establishes and operates funds for the benefit of its
employees. These funds are considered to be VIEs of which the Company is
the primary beneficiary.
The Company invests in certain distressed debt instruments of which the
issuers are VIEs. The Company has determined that it is the primary
beneficiary of such VIEs.
The Company has made investments in entities that own power plants.
Certain entities are VIEs of which the Company is the primary beneficiary.
The following table sets forth the Company's total assets and maximum
exposure to loss associated with its significant variable interests in
consolidated VIEs and securitizations that did not qualify for sale
treatment. This information is presented based on principal business
activity, as reflected in the first column.
As of May 31, 2007 As of November 30, 2006
--------------------------------------------------------------------------------------------------------
Maximum Maximum
Exposure Exposure
(in millions) VIE Assets to Loss (1) VIE Assets to Loss (1)
--------------------------------------------------------------------------------------------------------
Mortgage Securitizations $ 47,285 $ 1,249 $ 28,984 $ 762
Collateralized Debt and
Loan Obligations 1,809 143 685 48
Employee Funds(2) 718 497 575 355
Distressed Debt 56 56 59 59
Energy Investments 117 117 - -
--------------------------------------------------------------------------------------------------------
Total $ 49,985 $ 2,062 $ 30,303 $ 1,224
--------------------------------------------------------------------------------------------------------
(1) Represents the fair value of the Company's interest in these
entities.
(2) Maximum exposure to loss includes loans the Company has made to
employees who participate in the funds, for which the Company is in
a second loss position.
Note: Certain prior period amounts have been reclassified to conform to
the current period's presentation.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations for which the Company is not
the primary beneficiary and therefore does not consolidate these entities.
In aggregate, these VIEs had assets approximating $11.9 billion and $14.8
billion at May 31, 2007 and November 30, 2006, respectively. At May 31,
2007 and November 30, 2006, the Company's maximum exposure to loss from
these entities approximated $127.6 million and $163.2 million,
respectively, which represents the fair value of its interests and are
included in "Financial instruments owned, at fair value" in the Condensed
Consolidated Statements of Financial Condition.
The Company purchases and sells interests in entities that may be deemed
to be VIEs in its market-making capacity in the ordinary course of
business. As a result of these activities, it is reasonably possible that
such entities may be consolidated or deconsolidated at various points in
time. Therefore, the Company's variable interests included above may not
be held by the Company in future periods.
6. COLLATERALIZED FINANCING ARRANGEMENTS
The Company enters into secured borrowing and lending agreements to obtain
collateral necessary to effect settlements, finance inventory positions,
meet customer needs or re-lend as part of its dealer operations.
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company receives collateral under reverse repurchase agreements,
securities borrowing transactions, derivative transactions, customer
margin loans and other secured money-lending activities. In many
instances, the Company is also permitted by contract or custom to
rehypothecate securities received as collateral. These securities may be
used to secure repurchase agreements, enter into securities lending or
derivative transactions or cover short positions.
At May 31, 2007 and November 30, 2006, the fair value of securities
received as collateral by the Company that can be repledged, delivered or
otherwise used was approximately $329 billion and $286 billion,
respectively. Of these securities received as collateral, those with a
fair value of approximately $225 billion and $190 billion were delivered,
repledged or otherwise used at May 31, 2007 and November 30, 2006,
respectively.
The Company also pledges financial instruments owned to collateralize
certain financing arrangements and permits the counterparty to pledge or
rehypothecate the securities. These securities are recorded as "Financial
instruments owned and pledged as collateral, at fair value" in the
Condensed Consolidated Statements of Financial Condition. The carrying
value of securities and other inventory positions owned that have been
pledged or otherwise encumbered to counterparties where those
counterparties do not have the right to sell or repledge was approximately
$58 billion and $42 billion at May 31, 2007 and November 30, 2006,
respectively.
7. SHORT-TERM BORROWINGS
The Company obtains short-term borrowings through the issuance of
commercial paper and bank loans and other borrowings. The Company's
short-term borrowings at May 31, 2007 and November 30, 2006 consisted of
the following:
May 31, November 30,
(in billions) 2007 2006
------------------------------------------------------------------
Commercial paper $ 11.4 $ 20.7
Bank loans and other borrowings 6.0 5.1
------------------------------------------------------------------
Total unsecured short-term borrowings $ 17.4 $ 25.8
==================================================================
Note: Certain prior period amounts have been reclassified to conform to
the current period's presentation.
Committed Credit Facilities
The Company has a committed revolving credit facility ("Facility")
totaling $4.0 billion, which permits borrowing on a secured basis by the
Parent Company, BSSC, BSIL and certain other subsidiaries. The Facility
also allows the Parent Company, BSIL and Bear Stearns International
Trading Limited ("BSIT") to borrow up to $4.0 billion of the Facility on
an unsecured basis. Secured borrowings can be collateralized by both
investment-grade and non-investment-grade financial instruments as the
Facility provides for defined advance rates on a wide range of financial
instruments eligible to be pledged. The Facility contains financial
covenants, the most significant of which require maintenance of specified
levels of stockholders' equity of the Company and net capital of BSSC. The
Facility terminates in February 2008, with all loans outstanding at that
date payable no later than February 2009. There were no borrowings
outstanding under the Facility at May 31, 2007.
The Company has a $1.5 billion committed revolving securities repo
facility ("Repo Facility"), which permits borrowings secured by a broad
range of collateral under a repurchase arrangement by the Parent Company,
BSIL, BSIT and BSB. The Repo Facility contains financial covenants that
require, among other things, maintenance of specified levels of
stockholders' equity of the Company. The Repo Facility terminates in
August 2007, with all repos outstanding at that date payable no later than
August 2008. There were no borrowings outstanding under the Repo Facility
at May 31, 2007.
The Company has a $350 million committed revolving credit facility ("Pan
Asian Facility"), which permits borrowing on a secured basis by the Parent
Company, BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan
Asian Facility contains financial covenants that require, among other
things, maintenance of specified levels of
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
stockholders' equity of the Company and net capital of BSSC. The Pan Asian
Facility terminates in December 2007 with all loans outstanding at that
date payable no later than December 2008. There were no borrowings
outstanding under the Pan Asian Facility at May 31, 2007.
The Company has a $450 million committed revolving credit facility ("Tax
Lien Facility"), which permits borrowing on a secured basis by the Parent
Company, Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax
Lien Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the
Company. The Tax Lien Facility terminates in March 2008 with all loans
outstanding at that date payable no later than March 2009. There were no
borrowings outstanding under the Tax Lien Facility at May 31, 2007.
The Company also maintains a series of committed credit facilities, which
permit borrowing on a secured basis, to support liquidity needs for the
financing of investment-grade and non-investment-grade corporate loans,
residential mortgages, commercial mortgages, listed options and auto
loans. The facilities are expected to be drawn from time to time and
expire at various dates, the longest of such periods ending in fiscal
2009. All of these facilities contain a term-out option of one year or
more for borrowings outstanding at expiration. The banks providing these
facilities are committed to provide up to an aggregate of approximately
$6.4 billion. At May 31, 2007, the borrowings outstanding under these
committed credit facilities were $1.2 billion.
8. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at May 31, 2007 and November 30, 2006 consisted of the
following:
May 31, November 30
(in billions) 2007 2006,
-----------------------------------------------------------------------
Fixed rate notes due 2007 to 2037 $ 22.16 $ 22.52
Floating rate notes due 2007 to 2046 30.14 23.23
Index/equity/credit-linked notes 9.49 8.82
-----------------------------------------------------------------------
Total long-term borrowings $ 61.79 $ 54.57
=======================================================================
The Company's long-term borrowings include fair value adjustments as
elected under SFAS No. 133 as well as hybrid financial instruments
accounted for at fair value as elected under SFAS No. 155. During the six
months ended May 31, 2007, the Company issued and retired/repurchased
$12.98 billion and $5.38 billion of long-term borrowings, respectively.
The weighted average maturity of the Company's long-term borrowings, based
upon stated maturity dates, was approximately 4.3 years and 4.4 years at
May 31, 2007 and November 30, 2006, respectively.
9. EARNINGS PER SHARE
Basic EPS is computed by dividing net income applicable to common shares,
adjusted for costs related to vested shares under the CAP Plan, as well as
the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes
vested units issued under certain stock compensation plans, which will be
distributed as shares of common stock. Diluted EPS includes the
determinants of basic EPS and, in addition, gives effect to dilutive
potential common shares related to stock compensation plans.
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The computations of basic and diluted EPS are set forth below:
Three Months Ended Six Months Ended
------------------------------------------------------------------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands, except per share amounts) 2007 2006 2007 2006
------------------------------------------------------------------------------------------------------------------------
Net income $ 361,724 $ 539,333 $ 915,465 $ 1,053,489
Preferred stock dividends (5,257) (5,376) (10,514) (10,790)
Redemption of preferred stock - - - 27
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 10,075 12,597 24,125 24,374
------------------------------------------------------------------------------------------------------------------------
Net earnings used for basic EPS 366,542 546,554 929,076 1,067,100
Income adjustment (net of tax) applicable to deferred
compensation arrangements-nonvested shares 8,061 11,679 17,716 20,465
------------------------------------------------------------------------------------------------------------------------
Net earnings used for diluted EPS $ 374,603 $ 558,233 $ 946,792 $ 1,087,565
========================================================================================================================
Total basic weighted average common
shares outstanding (1) 131,684 132,810 132,384 132,779
------------------------------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 5,952 6,120 6,224 5,801
CAP and restricted units 11,110 11,016 10,618 11,201
------------------------------------------------------------------------------------------------------------------------
Dilutive potential common shares 17,062 17,136 16,842 17,002
------------------------------------------------------------------------------------------------------------------------
Weighted average number of common shares 148,746 149,946 149,226 149,781
outstanding and dilutive potential common shares
========================================================================================================================
Basic EPS $ 2.78 $ 4.12 $ 7.02 $ 8.04
Diluted EPS $ 2.52 $ 3.72 $ 6.34 $ 7.26
========================================================================================================================
(1) Includes 12,801,263 and 12,153,620 vested units for the three months
ended May 31, 2007 and 2006, respectively, and 13,301,397 and
13,409,146 vested units for the six months ended May 31, 2007 and
2006, respectively, issued under stock compensation plans which will
be distributed as shares of common stock.
10. REGULATORY REQUIREMENTS
The Company is regulated by the SEC as a consolidated supervised entity
("CSE"). As a CSE, the Company is subject to group-wide supervision and
examination by the SEC and is required to compute allowable capital and
allowances for market, credit and operational risk on a consolidated
basis. As of May 31, 2007, the Company was in compliance with the CSE
capital requirements.
Bear Stearns and BSSC are registered broker-dealers and futures commission
merchants and, accordingly, are subject to Rule 15c3-1 under the
Securities Exchange Act of 1934 ("Net Capital Rule") and Rule 1.17 under
the Commodity Futures Trading Commission. Bear Stearns uses Appendix E of
the Net Capital Rule ("Appendix E") which establishes alternative net
capital requirements for broker-dealers that are part of consolidated
supervised entities. Appendix E allows Bear Stearns to calculate net
capital charges for market risk and derivatives-related credit risk based
on mathematical models provided that Bear Stearns holds tentative net
capital in excess of $1 billion and net capital in excess of $500 million.
At May 31, 2007, Bear Stearns' net capital of $3.17 billion exceeded the
minimum requirement by $2.62 billion. Bear Stearns' net capital
computation, as defined, includes $411.2 million, which is net capital of
BSSC in excess of 5.5% of aggregate debit items arising from customer
transactions.
BSIL and Bear Stearns International Trading Limited ("BSIT"), London-based
broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the United Kingdom's Financial Services Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Financial Regulator.
Custodial Trust Company ("CTC"), a Federal Deposit Insurance Corporation
("FDIC") insured New Jersey state chartered bank, offers a range of trust,
lending and securities-clearing services. CTC provides the Company with
banking powers, including access to the securities and funds-wire services
of the Federal Reserve System. CTC is subject to the regulatory capital
requirements of the FDIC.
25
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
At May 31, 2007, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC were in
compliance with their respective regulatory capital requirements. Certain
other subsidiaries are subject to various securities regulations and
capital adequacy requirements promulgated by the regulatory and exchange
authorities of the countries in which they operate. At May 31, 2007, these
other subsidiaries were in compliance with their applicable local capital
adequacy requirements.
11. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
Leases
The Company occupies office space under leases that expire at various
dates through 2024. At May 31, 2007, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years 2007 through 2011
and the aggregate amount thereafter, are as follows:
(in millions)
--------------------------------------------
FISCAL YEAR
2007 (remaining) $ 54
2008 134
2009 120
2010 120
2011 121
Thereafter 747
--------------------------------------------
Total $ 1,296
============================================
Lending - Related Commitments
In connection with certain of the Company's business activities, the
Company provides financing or financing commitments to investment-grade
and non-investment-grade companies in the form of senior and subordinated
debt, including bridge financing. Commitments have varying maturity dates
and are generally contingent on the accuracy and validity of certain
representations, warranties and contractual conditions applicable to the
borrower. Lending-related commitments to investment-grade borrowers
aggregated approximately $4.0 billion and $3.8 billion at May 31, 2007 and
November 30, 2006, respectively. Of these amounts, approximately $680.8
million and $697.8 million of the credit risk was offset at May 31, 2007
and November 30, 2006, respectively. Lending-related commitments to
non-investment-grade borrowers approximated $2.3 billion and $2.0 billion
at May 31, 2007 and November 30, 2006, respectively. Of these amounts,
approximately $160.2 million and $88.8 million of the credit risk was
offset at May 31, 2007 and November 30, 2006, respectively.
The Company also had contingent commitments to investment-grade and
non-investment-grade companies of approximately $20.8 billion and $17.5
billion as of May 31, 2007 and November 30, 2006, respectively. Of these
amounts approximately $1.2 billion and $50.0 million of the credit risk
was offset at May 31, 2007 and November 30, 2006, respectively. Generally,
these commitments are provided in connection with leveraged acquisitions.
These commitments are not indicative of the Company's actual risk because
the borrower may not be successful in the acquisition, the borrower may
access the capital markets instead of drawing on the commitment, or the
Company's portion of the commitment may be reduced through the syndication
process. Additionally, the borrower's ability to draw may be subject to
there being no material adverse change in either market conditions or the
borrower's financial condition, among other factors. These commitments
generally contain certain flexible pricing features to adjust for changing
market conditions prior to closing.
26
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At May 31, 2007 and November 30, 2006, such
commitments aggregated $654.0 million and $788.3 million, respectively.
These commitments will be funded, if called, through the end of the
respective investment periods, with the longest of such periods ending in
2017.
Underwriting
In connection with the Company's mortgage-backed securitizations and fixed
income and equity underwriting, the Company had commitments to purchase
new issues of securities aggregating $1.3 billion and $205.0 million,
respectively, at May 31, 2007 and November 30, 2006.
Commercial and Residential Loans
The Company participates in the origination, acquisition, securitization,
servicing, financing and disposition of commercial and residential loans.
At May 31, 2007 and November 30, 2006, the Company had entered into
commitments to purchase or finance mortgage loans of $8.0 billion and $4.2
billion, respectively.
Letters of Credit
At May 31, 2007 and November 30, 2006, the Company was contingently liable
for unsecured letters of credit of approximately $3.7 billion and $3.3
billion, respectively, and secured (by financial instruments) letters of
credit of $348.8 million and $1.25 billion, respectively. These letters of
credit are primarily used to provide collateral for securities borrowed
and to satisfy margin requirements at commodity/futures exchanges.
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $206.6 million and $95.7 million, respectively, at May 31,
2007 and November 30, 2006.
With respect to certain of the commitments outlined above, the Company
utilizes various hedging strategies to actively manage its market, credit
and liquidity exposures. Additionally, since these commitments may expire
unused, the total commitment amount may not necessarily reflect the actual
future cash funding requirements.
Litigation
The Company is the sole defendant in an action commenced in the United
States Bankruptcy court for the Southern District of New York by the
Chapter 11 Trustee for Manhattan Investment Fund Limited. As previously
reported in the Company's Form 10-K for fiscal year ended November 30,
2006, the Bankruptcy Court granted the Trustee's motion for summary
judgment on the fraudulent transfer claims against the Company. The
Company has appealed the Bankruptcy Court's decision to the United States
District for the Southern District of New York.
In the normal course of business, the Company has been named as a
defendant in various legal actions, including arbitrations, class actions
and other litigation. Certain of the legal actions include claims for
substantial compensatory and/or punitive damages or claims for
indeterminate amounts of damages. The Company is also involved in other
reviews, investigations and proceedings by governmental and
self-regulatory agencies regarding the Company's business, certain of
which may result in adverse judgments, settlements, fines, penalties,
injunctions or other relief.
Because litigation is inherently unpredictable, particularly in cases
where claimants seek substantial or indeterminate damages or where
investigations and proceedings are in the early stages, the Company cannot
predict with certainty the loss or range of loss related to such matters,
how such matters will be resolved, when they will ultimately be resolved,
or what the eventual settlement, fine, penalty or other relief might be.
Consequently, the Company cannot estimate losses or ranges of losses for
matters where there is only a reasonable possibility that a loss may have
been
27
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
incurred. Although the ultimate outcome of these matters cannot be
ascertained at this time, it is the opinion of management, after
consultation with counsel, that the resolution of the foregoing matters
will not have a material adverse effect on the financial condition of the
Company, taken as a whole; such resolution may, however, have a material
effect on the operating results in any future period, depending on the
level of income for such period.
The Company has provided reserves for such matters in accordance with SFAS
No. 5, "Accounting for Contingencies." The ultimate resolution may differ
materially from the amounts reserved.
Tax
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the potential for additional assessments. Once established,
reserves are adjusted as information becomes available or when an event
requiring a change to the reserve occurs.
12. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. FIN No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others," requires the Company to recognize a liability
at the inception of certain guarantees and to disclose information about
its obligations under certain guarantee arrangements.
The guarantees covered by FIN No. 45 include contracts that contingently
require the guarantor to make payments to the guaranteed party based on
changes related to an asset, a liability or an equity security of the
guaranteed party, contracts that contingently require the guarantor to
make payments to the guaranteed party based on another entity's failure to
perform under an agreement and indirect guarantees of the indebtedness of
others, even though the payment to the guaranteed party may not be based
on changes to an asset, liability or equity security of the guaranteed
party. In addition, FIN No. 45 covers certain indemnification agreements
that contingently require the guarantor to make payments to the
indemnified party, such as an adverse judgment in a lawsuit or the
imposition of additional taxes due to either a change in the tax law or an
adverse interpretation of the tax law.
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of May 31, 2007:
Amount of Guarantee Expiration Per Period
---------------------------------------------------------------------------------
Less Than One to Three Three to Five Greater than
(in millions) One Year Years Years Five Years Total
------------------------------------------------------------------------------------------------------------------------------
Certain derivative contracts (notional) (1) $ 395,556 $ 370,442 $ 555,845 $ 619,063 $1,940,906
Municipal securities 3,538 236 - - 3,774
Residual value guarantee - - 570 - 570
------------------------------------------------------------------------------------------------------------------------------
(1) The carrying value of these derivatives approximated $505.2 million
as of May 31, 2007.
Derivative Contracts
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivative contracts that the
Company has entered into meet the accounting definition of a guarantee
under FIN No. 45. Derivatives that meet the FIN No. 45 definition of
guarantees include credit default swaps (whereby a default or significant
change in the credit quality of the underlying financial instrument may
obligate the Company to make a payment), put options, as well as floors,
caps and collars. Since the Company does not track the counterparties'
purpose for entering into a derivative contract, it has disclosed
derivative contracts that are likely to be used to protect against a
change in an underlying financial instrument, regardless of their actual
use.
On certain of these contracts, such as written interest rate caps and
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the
28
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
terms of the contracts. As such, the Company has disclosed notional
amounts as a measure of the extent of its involvement in these classes of
derivatives rather than maximum payout. Notional amounts do not represent
the maximum payout and generally overstate the Company's exposure to these
contracts. These derivatives contracts are recorded at fair value, which
approximated $505.2 million at May 31, 2007.
In connection with these activities, the Company mitigates its exposure to
market risk by entering into a variety of offsetting derivative contracts
and security positions.
Municipal Securities
In 1997, the Company established a program whereby it created a series of
municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds financed by the issuance of trust certificates. Certain of
the trust certificates entitle the holder to receive future payments of
principal and variable interest and to tender such certificates at the
option of the holder on a periodic basis. The Company acts as placement
agent and as liquidity provider. The purpose of the program is to allow
the Company's clients to purchase synthetic short-term, floating-rate
municipal debt that does not otherwise exist in the marketplace. In the
Company's capacity as liquidity provider to the trusts, the maximum
exposure to loss at May 31, 2007 was approximately $3.77 billion, which
represents the outstanding amount of all trust certificates. This exposure
to loss is mitigated by the underlying municipal bonds held by trusts. The
underlying municipal bonds in the trusts are either AAA or AA rated,
insured or escrowed to maturity. Such bonds had a market value, net of
related offsetting positions, approximating $3.86 billion at May 31, 2007.
Residual Value Guarantee
The Company has entered into an operating lease arrangement for its world
headquarters at 383 Madison Avenue in New York City (the "Synthetic
Lease"). Under the terms of the Synthetic Lease, the Company is obligated
to make monthly payments based on the lessor's underlying interest costs.
The Synthetic Lease expires on August 12, 2011 unless both parties agree
to a renewal prior to expiration. At the expiration date of the Synthetic
Lease, the Company has the right to purchase the building for the amount
of the then outstanding indebtedness of the lessor or to arrange for the
sale of the property with the proceeds of the sale to be used to satisfy
the lessor's debt obligation. If the sale of the property does not
generate sufficient proceeds to satisfy the lessor's debt obligation, the
Company is required to fund the shortfall up to a maximum residual value
guarantee. As of May 31, 2007, there was no expected shortfall and the
maximum residual value guarantee approximated $570 million.
Indemnifications
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third-party
originators upon acquisition of such assets. The Company generally
performs due diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to certain counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse application of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications.
Maximum payout information under these indemnifications is not readily
available because of the number, size and lives of these transactions. In
implementing this accounting interpretation, the Company reviewed its
experience with the indemnifications on these structures. Based on such
experience, it is unlikely that these arrangements will have a material
impact on the Condensed Consolidated Financial Statements of the Company.
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Therefore, if a member becomes
29
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
unable to satisfy its obligations to the clearinghouse, other members
would be required to meet these shortfalls. To mitigate these performance
risks, the exchanges and clearinghouses often require members to post
collateral. The Company's maximum potential liability under these
arrangements cannot be quantified. However, the potential for the Company
to be required to make payments under these arrangements is remote.
Accordingly, no contingent liability is recorded in the Condensed
Consolidated Financial Statements for these arrangements.
13. SEGMENT DATA
The Company operates in three principal segments -- Capital Markets,
Global Clearing Services and Wealth Management. These segments offer
different products and services and are managed separately as different
levels and types of expertise are required to effectively manage the
segments' transactions.
The Capital Markets segment comprises the institutional equities, fixed
income and investment banking areas. The Capital Markets segment operates
as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses work in tandem to deliver these
services to institutional and corporate clients.
Institutional equities consists of sales, trading and research, in areas
such as domestic and international equities, block trading,
over-the-counter equities, equity derivatives, energy and commodity
activities, risk and convertible arbitrage and specialist activities on
the NYSE, AMEX and ISE. Fixed income includes sales, trading, origination
and research provided to institutional clients across a variety of
products such as mortgage- and asset-backed securities, corporate and
government bonds, municipal bonds, high yield products, including bank and
bridge loans, foreign exchange and interest rate and credit derivatives.
Investment banking provides services in capital raising, strategic advice,
mergers and acquisitions and merchant banking. Capital raising encompasses
the Company's underwriting of equity, investment grade, municipal and high
yield debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the United States
and abroad.
The three business segments comprise many business areas, with
interactions among each. Revenues and expenses include those that are
directly related to each segment. Revenues from intersegment transactions
are based upon specific criteria or agreed upon rates with such amounts
eliminated in consolidation. Individual segments also include revenues and
expenses relating to various items, including corporate overhead and
interest, which are internally allocated by the Company primarily based on
balance sheet usage or expense levels. The Company generally evaluates
performance of the segments based on net revenues and profit or loss
before provision for income taxes.
30
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months ended Six Months ended
-----------------------------------------------------------------------
(in thousands) May 31, 2007 May 31, 2006 May 31, 2007 May 31, 2006
------------------------------------------------------------------------------------------------------------
NET REVENUES
Capital Markets
Institutional Equities $ 542,685 $ 560,496 $ 1,055,338 $ 1,060,389
Fixed Income 962,287 1,222,537 2,111,639 2,129,675
Investment Banking 356,861 278,259 659,970 573,809
------------------------------------------------------------------------------------------------------------
Total Capital Markets 1,861,833 2,061,292 3,826,947 3,763,873
Global Clearing Services 316,785 287,171 592,343 550,596
Wealth Management
Private Client Services (1) 157,266 130,059 293,419 259,670
Asset Management 184,114 22,999 303,273 118,075
------------------------------------------------------------------------------------------------------------
Total Wealth Management 341,380 153,058 596,692 377,745
Other (2) (8,022) (2,079) (22,234) (7,569)
------------------------------------------------------------------------------------------------------------
Total net revenues $ 2,511,976 $ 2,499,442 $ 4,993,748 $ 4,684,645
============================================================================================================
PRE-TAX INCOME
Capital Markets $ 376,927(4) $ 759,391 $ 1,113,238(4) $ 1,411,718
Global Clearing Services 154,751 136,411 267,551 261,270
Wealth Management 56,465 (11,801) 100,218 19,985
Other ((3)) (34,486) (49,802) (92,144) (106,421)
---------------------------------------------------------------------------------------------------------------
Total pre-tax income $ 553,657 $ 834,199 $ 1,388,863 $ 1,586,552
===============================================================================================================
Three Months ended Six Months ended
------------------------------- ---------------------------------
May 31, 2007 May 31, 2006 May 31, 2007 May 31, 2006
------------------------------- ---------------------------------
(1) Private Client Services detail:
Gross revenues, before
transfer to Capital Markets
segment $ 185,082 $ 154,184 $ 350,671 $ 308,079
Revenue transferred
to Capital Markets segment (27,816) (24,125) (57,252) (48,409)
------------------------------ ---------------------------------
Private Client Services net
revenues $ 157,266 $ 130,059 $ 293,419 $ 259,670
============================== =================================
(2) Includes consolidation and elimination entries.
(3) Includes certain legal costs and costs related to the CAP Plan.
(4) Includes a non-cash charge of $227.5 million related to the write-off of
intangible assets, representing goodwill and specialist rights associated
with our NYSE specialist activities.
As of
------------------------------------------------------------------
May 31, November 30,
(in billions) 2007 2006
------------------------------------------------------------------
SEGMENT ASSETS
Capital Markets $ 278 $ 240
Global Clearing Services 125 99
Wealth Management 4 3
Other 16 8
------------------------------------------------------------------
Total segment assets $ 423 $ 350
==================================================================
31
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
14. ACQUISITION OF MINORITY INTEREST AND IMPAIRMENT OF INTANGIBLE ASSETS
At the close of business on April 30, 2007, the Company completed an
acquisition of the outstanding minority interest in Bear Hunter Holdings
LLC (the parent of Bear Wagner Specialists) from its partner, Hunter
Partners LLC.
The Company tests goodwill at least annually for impairment in accordance
with SFAS No. 142 by comparing the fair value of a reporting unit with the
carrying amount, including goodwill. In addition, the Company amortizes
identifiable intangible assets over their estimated useful lives in
accordance with SFAS No. 142 and tests for potential impairment whenever
events or changes in circumstances suggest that an asset's carrying value
may not be fully recoverable in accordance with SFAS No. 144. An
impairment loss, calculated as the difference between the estimated fair
value and the carrying value of an asset, is recognized if the expected
undiscounted cash flows relating to the asset are less than the
corresponding carrying value.
During the fourth quarter of fiscal 2006, the New York Stock Exchange
introduced its Hybrid trading system, a new electronic trading system
designed to make it more competitive. The Hybrid trading system automates
certain of the tasks previously performed by specialists and dramatically
reduces the opportunity for specialists to participate in the order
process. The Company has monitored the impact of the introduction of the
Hybrid trading system on its specialist business. As a result, during the
May 2007 quarter, the Company tested its goodwill and specialist rights
associated with its NYSE specialist activities and recognized a non-cash
impairment charge of $227.5 million relating to the original purchase of
Wagner Stott Mercator, LLC in April 2001. The impairment charge is
included on a separate line item on the Condensed Consolidated Statements
of Income and within the Company's Capital Markets segment for the three
months and six months ended May 31, 2007.
15. BUSINESS ACQUISITION
On May 20, 2007, Bear Energy LP, a Houston-based, wholly owned subsidiary
of the Company, signed a definitive agreement to acquire substantially all
of the power-related assets comprising the power trading business of
Williams Power Company, Inc., an energy trading and marketing subsidiary
of The Williams Companies, Inc. for cash consideration of $512 million,
subject to adjustments specified in the Asset Purchase Agreement. The
transaction, which is subject to regulatory and other approvals, is
expected to close during the fiscal fourth quarter ending November 30,
2007. The results of operations of the power-related assets acquired will
be included in the Company's Capital Markets segment.
16. SUBSEQUENT EVENT
On June 7, 2007, Bear Stearns Asset Management ("BSAM"), the investment
manager of the Bear Stearns High-Grade Structured Credit Strategies Fund
(the "High-Grade Fund") and the Bear Stearns High-Grade Structured Credit
Strategies Enhanced Leverage Fund (the "Enhanced Fund") (collectively the
"Funds") announced to investors that there would be a suspension of
investor redemptions in the Enhanced Fund. Subsequent to the announcement,
the Funds were not capable of raising additional liquidity necessary to
meet margin calls made by secured financing counterparties. As a result,
various counterparties moved to seize collateral or otherwise terminate
financing arrangements by arranging to acquire the relevant collateral at
negotiated prices. During June, the Funds experienced significant declines
in the value of their assets resulting in losses in net asset value. As of
April 30, 2007, the last reported valuation date, the Funds had net assets
of approximately $1.6 billion.
On June 22, 2007, the Company entered into a $1.6 billion secured
financing agreement (the "Facility") with the High-Grade Fund. The
Facility, which is in the form of collateralized repurchase agreements,
enabled the High-Grade Fund to replace existing secured financing, thereby
improving the High-Grade Fund's liquidity and allowing an orderly
de-leveraging of the High-Grade Fund in the marketplace. Currently, we
believe the High-Grade Fund has sufficient assets available to fully
collateralize the Facility.
The Company continues to work with the creditors and counterparties of the
Enhanced Fund to facilitate an orderly de-leveraging of the Enhanced Fund.
Currently, outstanding repurchase agreement balances in the Enhanced Fund
are approximately $600 million. The Company has not provided financing to
the Enhanced Fund.
At May 31, 2007, the Company had a direct investment in the Enhanced Fund
of approximately $34 million and had unsecured receivables of
approximately $43 million from the Funds.
32
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
The Bear Stearns Companies Inc.
We have reviewed the accompanying condensed consolidated statement of
financial condition of The Bear Stearns Companies Inc. and subsidiaries as of
May 31, 2007, and the related condensed consolidated statements of income for
the three-month and six-month periods ended May 31, 2007 and 2006 and
cash flows for the six-month periods ended May 31, 2007 and 2006. These
interim financial statements are the responsibility of The Bear Stearns
Companies Inc.'s management.
We conducted our reviews in accordance with the standards of the Public
Company Accounting Oversight Board (United States). A review of interim
financial information consists principally of applying analytical procedures
and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in
accordance with the standards of the Public Company Accounting Oversight
Board (United States), the objective of which is the expression of an opinion
regarding the financial statements taken as a whole. Accordingly, we do not
express such an opinion.
Based on our reviews, we are not aware of any material modifications that
should be made to such condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America.
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated
statement of financial condition of The Bear Stearns Companies Inc. and
subsidiaries as of November 30, 2006, and the related consolidated statements
of income, cash flows and changes in stockholders' equity for the fiscal year
then ended (not presented herein); and in our report dated February 12, 2007,
we expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the accompanying
condensed consolidated statement of financial condition as of November 30,
2006 is fairly stated, in all material respects, in relation to the
consolidated statement of financial condition from which it has been derived.
/s/ Deloitte & Touche LLP
New York, New York
July 9, 2007
33
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The Bear Stearns Companies Inc. (the "Company") is a holding company that
through its broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"),
Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB"),
is a leading investment banking, securities and derivatives trading, clearance
and brokerage firm serving corporations, governments, institutional and
individual investors worldwide. BSSC, a subsidiary of Bear Stearns, provides
professional and correspondent clearing services in addition to clearing and
settling customer transactions and certain proprietary transactions of the
Company. The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited; Custodial
Trust Company; Bear Stearns Financial Products Inc.; Bear Stearns Capital
Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.; EMC
Mortgage Corporation; Bear Stearns Commercial Mortgage, Inc.; and Bear Hunter
Holdings LLC. The Company is primarily engaged in business as a securities
broker-dealer operating in three principal segments: Capital Markets, Global
Clearing Services and Wealth Management. As used in this report, the "Company"
refers (unless the context requires otherwise) to The Bear Stearns Companies
Inc. and its subsidiaries. Unless specifically noted otherwise, all references
to the three and six months of 2007 and 2006 refer to the three and six months
ended May 31, 2007 and 2006, respectively, and all references to quarters are to
the Company's fiscal quarters.
For a description of the Company's business, including its trading in cash
instruments and derivative products, its underwriting and trading policies, and
their respective risks, and the Company's risk management policies and
procedures, see the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2006, as filed by the Company under the Securities Exchange
Act of 1934, as amended ("Exchange Act").
The Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read together with the Management's Discussion and Analysis
of Financial Condition and Results of Operations and the Consolidated Financial
Statements in the Company's Annual Report on Form 10-K.
CERTAIN FACTORS AFFECTING RESULTS OF OPERATIONS
The Company's principal business activities--investment banking, securities and
derivatives sales and trading, clearance, brokerage and asset management--are,
by their nature, highly competitive and subject to various risks, including
volatile trading markets and fluctuations in the volume of market activity.
Consequently, the Company's net income and revenues have been, and are likely to
continue to be, subject to wide fluctuations, reflecting the effect of many
factors, including general economic conditions, securities market conditions,
the level and volatility of interest rates and equity prices, competitive
conditions, liquidity of global markets, international and regional political
conditions, regulatory and legislative developments, monetary and fiscal policy,
investor sentiment, availability and cost of capital, technological changes and
events, outcome of legal proceedings, changes in currency values, inflation,
credit ratings and the size, volume and timing of transactions.
These and other factors can affect the Company's volume of new securities
issuances, mergers and acquisitions and business restructurings; the stability
and liquidity of securities and futures markets; and the ability of issuers,
other securities firms and counterparties to perform on their obligations. A
decrease in the volume of new securities issuances, mergers and acquisitions or
restructurings generally results in lower revenues from investment banking and,
to a lesser extent, reduced principal transactions. A reduced volume of
securities and futures transactions and reduced market liquidity generally
results in lower revenues from principal transactions and commissions. Lower
price levels for securities may result in a reduced volume of transactions, and
may also result in losses from declines in the market value of securities held
in proprietary trading and underwriting accounts. In periods of reduced sales
and trading or investment banking activity, profitability may be adversely
affected because certain expenses remain relatively fixed. The Company's
securities trading, derivatives, arbitrage, market-making, specialist, leveraged
lending, leveraged buyout and underwriting activities are conducted by it on a
principal basis and expose the Company to significant risk of loss. Such risks
include market, counterparty credit and liquidity risks. For a discussion of how
the Company seeks to manage risks, see the "Risk Management" and "Liquidity and
Capital Resources" sections of the Company's Annual Report on Form 10-K.
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Substantial legal liability or a significant regulatory action against the
Company could have a material adverse effect or cause significant reputational
harm to the Company, which in turn could seriously harm the Company's business
prospects. Firms in the financial services industry have been operating in a
stringent regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements concerning management's expectations, strategic
objectives, business prospects, anticipated economic performance and financial
condition and other similar matters are subject to risks and uncertainties,
including those described in the prior paragraphs, which could cause actual
results to differ materially from those discussed in the forward-looking
statements. Forward-looking statements speak only as of the date of the document
in which they are made. We disclaim any obligation or undertaking to provide any
updates or revisions to any forward-looking statement to reflect any change in
our expectations or any change in events, conditions or circumstances on which
the forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results
Revenues, net of interest expense ("net revenues") for the three months ended
May 31, 2007 increased 0.5% to a record $2.51 billion from $2.50 billion for the
three months ended May 31, 2006, while pre-tax earnings decreased 33.6% during
the same period. Pre-tax profit margins for the 2007 quarter decreased to 22.0%
when compared with 33.4% in the 2006 quarter. Annualized return on average
common equity was 11.6% for the quarter ended May 31, 2007 compared with 20.1%
in the 2006 quarter. Included in the second quarter results was a non-cash
charge of $227.5 million related to the write-off of intangible assets,
representing goodwill and specialist rights, associated with New York Stock
Exchange ("NYSE") specialist activities. Excluding the $227.5 million charge to
intangible assets, pre-tax profit margin and annualized return on average common
equity for the 2007 quarter would have been 30.7% and 15.6%, respectively.
Capital Markets net revenues for the 2007 quarter decreased compared with the
2006 quarter due to decreased net revenues from fixed income and institutional
equities, partially offset by increased net revenues from investment banking.
Fixed income net revenues decreased in the 2007 quarter from the comparable
prior year quarter, primarily due to weaker U.S. mortgage and global interest
rate markets. Challenging market conditions in the U.S. residential mortgage
business were experienced in the 2007 quarter as difficulties in the sub-prime
mortgage market continued to be a concern. As a result, revenues from the
Company's mortgage-related businesses declined significantly during the 2007
quarter. In addition, interest rate derivatives and foreign exchange revenues
decreased during the 2007 quarter as the lack of volatility in the global
interest rate markets served to suppress customer volumes. However, credit
markets remained favorable as spreads remained tight and leveraged finance
volumes increased significantly. As a result, strong performances from the
structured credit trading and leveraged finance areas were achieved in the 2007
quarter compared with the 2006 quarter. Institutional equities net revenues
decreased slightly in the 2007 quarter from the comparable prior year quarter.
Revenues from specialist activities decreased in the 2007 quarter resulting from
the implementation of the NYSE Hybrid system. Energy related revenues also
decreased in the 2007 quarter as the prior year quarter included significant
gains from the monetization of certain energy properties. Substantially
offsetting these decreases were record net revenues in the structured equity
products and risk arbitrage areas, reflecting favorable market conditions.
Investment Banking net revenues increased in the 2007 quarter compared with the
2006 quarter, reflecting a favorable mergers and acquisitions ("M&A")
environment and an active calendar for equity and high yield underwritings.
Merchant banking revenues also increased, reflecting higher net gains on the
Company's portfolio of investments.
Global Clearing Services net revenues increased to record levels in the 2007
quarter. Net interest revenues increased in the 2007 quarter, partially offset
by reduced commission revenues. Prime broker margin debt and customer short
balances reached record levels during the 2007 quarter.
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Wealth Management net revenues increased during the 2007 quarter driven by
increases in both Asset Management and Private Client Services ("PCS") net
revenues. Asset Management net revenues increased on higher performance fees and
management fees on both traditional and alternative assets under management. PCS
revenues increased on growth in fee- based assets.
The results achieved during the second quarter of 2007 reflect our continued
success in expanding and diversifying our franchise both domestically and
internationally. From a geographical perspective, net revenues from our
international activities increased by 57.3% to $505.1 million.
Asset Management
On June 7, 2007, Bear Stearns Asset Management ("BSAM"), the investment manager
of the Bear Stearns High-Grade Structured Credit Strategies Fund (the
"High-Grade Fund") and the Bear Stearns High-Grade Structured Credit Strategies
Enhanced Leverage Fund (the "Enhanced Fund") (collectively the "Funds")
announced to investors that there would be a suspension of investor redemptions
in the Enhanced Fund. Subsequent to the announcement, the Funds were not capable
of raising additional liquidity necessary to meet margin calls made by secured
financing counterparties. As a result, various counterparties moved to seize
collateral or otherwise terminate financing arrangements by arranging to acquire
the relevant collateral at negotiated prices. During June, the Funds experienced
significant declines in the value of their assets resulting in losses in net
asset value. As of April 30, 2007, the last reported valuation date, the Funds
had net assets of approximately $1.6 billion.
On June 22, 2007, the Company entered into a $1.6 billion secured financing
agreement (the "Facility") with the High-Grade Fund. The Facility, which is in
the form of collateralized repurchase agreements, enabled the High-Grade Fund to
replace existing secured financing, thereby improving the High-Grade Fund's
liquidity and allowing an orderly de-leveraging of the High-Grade Fund in the
marketplace. Currently, we believe the High-Grade Fund has sufficient assets
available to fully collateralize the Facility.
The Company continues to work with the creditors and counterparties of the
Enhanced Fund to facilitate an orderly de-leveraging of the Enhanced Fund.
Currently, outstanding repurchase agreement balances in the Enhanced Fund are
approximately $600 million. The Company has not provided financing to the
Enhanced Fund.
At May 31, 2007, the Company had a direct investment in the Enhanced Fund of
approximately $34 million and had unsecured receivables of approximately $43
million from the Funds.
On June 29, 2007, the Company announced the hiring of Jeffrey Lane as Chairman
and CEO of BSAM. The difficulties surrounding the two BSAM managed funds could
negatively impact BSAM's ability to sustain existing assets under management,
attract new investors or otherwise impair other aspects of the Company's asset
management business. While we believe the Company's businesses remain strong,
the Company is unable to determine what impact, if any, these developments may
have on its business.
In June 2007, the four major rating agencies (S&P, Moody's, Fitch, and DBRS)
affirmed the ratings of The Bear Stearns Companies Inc. in individual press
releases. In addition to affirming the Company's ratings, DBRS also confirmed
the Positive trend on the ratings. Citing the recent difficulties faced by two
hedge funds managed by BSAM, the four rating agencies stated that the Company
has the financial capacity and ample liquidity to provide support for the
High-Grade Fund, while continuing to work with creditors and counterparties of
the Enhanced Fund to reduce leverage and improve liquidity.
Business Environment
Fiscal 2007 Quarter
The business environment during the Company's second quarter ended May 31, 2007
was generally favorable due to a combination of factors including low
unemployment, low interest rates, and strong consumer confidence. The
unemployment rate was 4.5% at the end of May 2007, reflecting a strong labor
market. Consumer sentiment was strong during the 2007 quarter as higher equity
prices and low unemployment appeared to outweigh the negative impact of higher
energy prices and a weaker housing market. The Federal Reserve Board (the "Fed")
met twice during the 2007 quarter, leaving the federal funds rate unchanged at
5.25%. In its May 2007 statement, the Fed noted core inflation remained somewhat
elevated and that future policy adjustments would depend on the evolution of the
outlook for both inflation and economic growth.
Each of the major U.S. equity indices increased during the 2007 quarter. The
Standard & Poor's 500 Index ("S&P 500"), the Dow Jones Industrial Average
("DJIA"), and the National Association of Securities Dealers Automated
Quotations ("NASDAQ") Composite Index ("NASDAQ Composite Index") increased 8.8%,
11.1% and 7.8%, respectively, during the 2007 quarter. Average daily trading
volume on the NYSE decreased 4.9% while average daily trading volume on the
NASDAQ increased 2.2% in the 2007 quarter, compared to the 2006 quarter.
Industry-wide U.S.-announced M&A volumes increased 35.4% while industry-wide
U.S.-completed M&A volumes increased 33.3% compared to the second quarter of
2006. Total equity issuance volumes increased 20.9% while initial public
offering ("IPO") volumes increased 11.4% compared to the 2006 quarter.
Fixed income activity was adversely affected by weaker U.S. mortgage and global
interest rate markets during the 2007 quarter. Long-term interest rates, as
measured by the 10-year Treasury bond, increased during the 2007 quarter. The
10-year Treasury bond yield was 4.89% at the end of the 2007 quarter, up from
4.57% at the beginning of the quarter. Stricter underwriting standards resulted
in a decrease in the level of loan originations, particularly in the sub-prime
mortgage market which, in the 2007 quarter, decreased significantly from the
levels reached during fiscal 2006. Overall U.S. mortgage-backed securities new
issue volume decreased 0.1% during the 2007 quarter compared with the results
achieved in the 2006 quarter. Agency collateralized mortgage obligation ("CMO")
security volumes decreased approximately 3.1% industry-wide during the 2007
quarter from the levels reached in the 2006 quarter, while non-agency
mortgage-backed origination volumes decreased approximately 6.9% industry-wide
compared to the 2006 quarter.
Fiscal 2006 Quarter
The business environment during the second quarter ended May 31, 2006 was
characterized by an expanding U.S. economy, strong U.S. capital market
conditions and low unemployment. The Fed met twice during the quarter and raised
the federal funds rate, in 25 basis point increments, from 4.5% to 5%, citing a
continued effort to keep inflationary pressures low in the midst of a cooling
housing market and increasing energy costs. In May 2006, the unemployment rate
fell to 4.6%, its lowest rate for the year. Oil prices closed at $71 a barrel at
the end of May, up 16% from the prior quarter's close of $61.
The major indices were mixed during the second quarter of 2006. The DJIA
increased 1.6%, while the NASDAQ Composite Index and the S&P 500 decreased 4.5%
and 0.8%, respectively, during the quarter. Average daily trading volume on the
NASDAQ and the NYSE increased 19.0% and 5.9%, respectively, in the 2006 quarter,
compared to the 2005 quarter. M&A activity was robust during the 2006 quarter.
Industry-wide U.S.-announced M&A volumes increased 86% while industry-wide
U.S.-completed M&A volumes increased 115% compared to the prior year quarter.
Total equity issuance volumes increased 100% while IPO volumes increased 99%
compared to the 2005 quarter.
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Fixed income activity was robust during the 2006 quarter despite the increase in
short-term interest rates and a flattening yield curve. Long-term interest rates
increased during the 2006 quarter. The 10-year Treasury bond yield increased to
5.11% at the end of the 2006 quarter from 4.56% at the beginning of the quarter.
The housing market experienced declines in refinancing and purchasing levels as
rates for 30-year fixed rate mortgages increased modestly during the 2006
quarter. However, overall U.S. mortgage-backed securities new issue volume
increased 51% during the 2006 quarter compared with the results achieved in the
2005 quarter. Non-agency mortgage-backed origination volumes increased
approximately 88% industry-wide during the 2006 quarter from the levels reached
in the 2005 quarter.
RESULTS OF OPERATIONS
Firmwide Results
The following table sets forth an overview of the Company's financial results:
Three Months Ended Six Months Ended
(in thousands, except per share amounts, --------------------------------------------------------------------------------------
pre-tax profit margin and return on May 31, May 31, % Increase May 31, May 31, % Increase
average common equity) 2007 2006 (Decrease) 2007 2006 (Decrease)
------------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 2,511,976 $ 2,499,442 0.5% $ 4,993,748 $ 4,684,645 6.6%
Income before provision for income taxes $ 553,657 $ 834,199 (33.6%) $ 1,388,863 $ 1,586,552 (12.5%)
Net income $ 361,724 $ 539,333 (32.9%) $ 915,465 $ 1,053,489 (13.1%)
Diluted earnings per share $ 2.52 $ 3.72 (32.3%) $ 6.34 $ 7.26 (12.7%)
Pre-tax profit margin 22.0% 33.4% 27.8% 33.9%
Return on average common equity (annualized) 11.6% 20.1% 14.9% 20.1%
------------------------------------------------------------------------------------------------------------------------------------
The Company reported net income of $361.7 million, or $2.52 per share (diluted),
for the quarter ended May 31, 2007, which represented a decrease of 32.9% from
$539.3 million, and 32.3% from $3.72 per share (diluted), for the quarter ended
2006. Included in the second quarter results was a non-cash charge of $227.5
million or $0.88 per share (diluted), related to the write-off of intangible
assets, representing goodwill and specialist rights, associated with our NYSE
specialist activities. Excluding the $227.5 million charge to intangible assets,
the Company would have reported net income of $486.0 million, or $3.40 per share
(diluted), for the quarter ended May 31, 2007, which would have represented a
decrease of 9.9% from $539.3 million, and 8.6% from $3.72 per share (diluted),
for the quarter ended 2006. Net revenues increased 0.5% to a record $2.51
billion for the quarter ended May 31, 2007 from $2.50 billion for the quarter
ended 2006, due to increases in asset management and other revenues, investment
banking revenues, net interest revenues, and commission revenues, partially
offset by a decrease in principal transactions revenues.
The Company reported net income of $915.5 million, or $6.34 per share (diluted),
for the six months ended May 31, 2007, which represented a decrease of 13.1%
from $1.05 billion, and 12.7% from $7.26 per share (diluted), for the six months
ended 2006. The results for the six months ended 2007 also includes the non-cash
charge of $227.5 million or $0.88 per share (diluted), related to the write-off
of intangible assets associated with our NYSE specialist activities. Excluding
the $227.5 million charge to intangible assets, the Company would have reported
net income of $1.04 billion, or $7.22 per share (diluted), for the six months
ended May 31, 2007, which would have represented a decrease of 1.3% from $1.05
billion, and 0.6% from $7.26 per share (diluted), for the six months ended 2006.
Net revenues increased 6.6% to $4.99 billion for the six months ended May 31,
2007 from $4.68 billion for the six months ended 2006, due to increases in asset
management and other revenues, net interest revenues, and investment banking
revenues, partially offset by decreases in principal transactions revenues and
commission revenues.
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's commission revenues by reporting category were as follows:
Three Months Ended Six Months Ended
-----------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, % Increase
(in thousands) 2007 2006 (Decrease) 2007 2006 (Decrease)
---------------------------------------------------------------------------------------------------
Institutional $ 212,857 $ 205,536 3.6% $ 405,571 $ 393,976 2.9%
Clearance 56,943 62,607 (9.0%) 110,459 121,803 (9.3%)
Retail 35,854 37,108 (3.4%) 70,269 75,543 (7.0%)
---------------------------------------------------------------------------------------------------
Total commissions $ 305,654 $ 305,251 0.1% $ 586,299 $ 591,322 (0.8%)
===================================================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Commission revenues for the 2007 quarter increased 0.1% to $305.7 million from
$305.3 million for the comparable prior year quarter. Institutional commissions
increased 3.6% to $212.9 million for the 2007 quarter from $205.5 million for
the comparable prior year quarter due to higher average trading volumes on the
NASDAQ and increased market share within the over-the-counter market compared
with the 2006 quarter. Clearance commissions decreased 9.0% to $56.9 million for
the 2007 quarter from $62.6 million for the comparable prior year quarter
reflecting lower average rates from prime brokerage clients and lower average
trading volumes from fully-disclosed clients. Retail commissions were $35.9
million in the 2007 quarter, down slightly from $37.1 million in the 2006
quarter.
Commission revenues for the six months ended May 31, 2007 decreased 0.8% to
$586.3 million from $591.3 million for the comparable prior year period.
Institutional commissions increased 2.9% to $405.6 million for the 2007 period
from $394.0 million for the comparable prior year period due to an increase in
average trading volumes on the NASDAQ compared with the 2006 period. Clearance
commissions decreased 9.3% to $110.5 million for the 2007 period from $121.8
million for the comparable prior year period reflecting lower average rates from
prime brokerage clients and lower average trading volumes from fully-disclosed
clients. Retail commissions decreased 7.0% to $70.3 million in the 2007 period
from $75.5 million in the comparable prior year period primarily due to the
transfer of certain accounts from a commission-based to a fee-based platform.
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended Six Months Ended
-----------------------------------------------------------------------------
May 31, May 31, May 31, May 31, % Increase
(in thousands) 2007 2006 % (Decrease) 2007 2006 (Decrease)
------------------------------------------------------------------------------------------------------------------
Fixed income $ 810,593 $1,063,634 (23.8%) $1,780,567 $1,866,551 (4.6%)
Equities 412,371 428,844 (3.8%) 784,774 776,359 1.1%
------------------------------------------------------------------------------------------------------------------
Total principal transactions $1,222,964 $1,492,478 (18.1%) $2,565,341 $2,642,910 (2.9%)
==================================================================================================================
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Revenues from principal transactions for the 2007 quarter decreased 18.1% to
$1.22 billion from $1.49 billion for the 2006 quarter. Fixed income revenues
decreased 23.8% to $810.6 million for the 2007 quarter from $1.06 billion for
the 2006 quarter primarily due to weaker U.S. mortgage market conditions
associated with increased delinquencies in the sub-prime mortgage sector.
Revenues derived from equities activities decreased 3.8% to $412.4 million
during the 2007 quarter from $428.8 million in the 2006 quarter primarily due to
a decrease in NYSE specialist and energy-related revenues, substantially offset
by an increase in revenues from structured equity products and risk arbitrage.
Revenues from principal transactions for the six months ended May 31, 2007
decreased 2.9% to $2.57 billion from $2.64 billion for the comparable prior year
period. Fixed income revenues decreased 4.6% to $1.78 billion for the 2007
period from $1.87 billion for the comparable prior year period. Mortgage-backed
securities revenues decreased when compared to the 2006 period due to the more
challenging U.S. mortgage market. This decrease was substantially offset by
record revenues in structured credit trading resulting from favorable credit
markets and increased volumes. Revenues derived from equities activities
increased 1.1% to $784.8 million during the six months ended May 31, 2007 from
$776.4 million in the 2006 period. Net revenues from risk arbitrage, structured
equity products, and international equity sales and trading rose, substantially
offset by a decrease in revenues from specialist activities and energy-related
activities.
38
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended Six Months Ended
----------------------------------------------------------------------------
May 31, May 31, May 31, May 31, % Increase
(in thousands) 2007 2006 % Increase 2007 2006 (Decrease)
-----------------------------------------------------------------------------------------------------------------
Underwriting $ 162,360 $ 132,099 22.9% $ 317,616 $ 263,499 20.5%
Advisory and other fees 223,308 190,555 17.2% 384,495 325,547 18.1%
Merchant banking 18,603 (4,504) nm 52,339 66,957 (21.8%)
-----------------------------------------------------------------------------------------------------------------
Total investment banking $ 404,271 $ 318,150 27.1% $ 754,450 $ 656,003 15.0%
=================================================================================================================
nm - not meaningful
Investment banking revenues increased 27.1% to $404.3 million for the 2007
quarter from $318.2 million for the 2006 quarter. Equity and high yield
underwriting revenues increased for the 2007 quarter, due to higher new issue
volumes. Advisory and other fees increased on higher levels of M&A activity and
an increase in mortgage servicing fees. In addition, merchant banking revenues
increased, reflecting higher gains on the Company's portfolio of investments and
higher performance fees on managed merchant banking funds.
Investment banking revenues increased 15.0% to $754.5 million for the six months
ended May 31, 2007 from $656.0 million for the 2006 period primarily due to
higher equity underwriting revenues resulting from improved global equity market
conditions. Advisory and other fees increased in the 2007 period, reflecting an
improved M&A environment and an increase in mortgage servicing fees. Merchant
banking revenues decreased in the 2007 period on lower gains from principal
investments and lower performance fees which occurred in the first quarter of
2007.
Net interest revenues (interest and dividends revenue less interest expense)
increased 11.6% to $342.3 million for the 2007 quarter from $306.6 million for
the 2006 quarter and increased 18.4% to $683.5 million for the six months ended
May 31, 2007 from $577.3 million for the 2006 period. The increase in net
interest revenues was primarily attributable to higher average customer margin
debt balances and customer short balances.
Asset management and other revenues increased 207.6% to $236.8 million for the
2007 quarter from $77.0 million for the 2006 quarter and increased 86.2% to
$404.2 million for the six months ended May 31, 2007 from $217.1 million for the
2006 period. These increases reflect growth in performance fees on proprietary
hedge fund products as well as improved investment returns on proprietary
investments and growth in management fees on higher levels of traditional and
alternative assets under management. PCS net revenues also increased due to
higher levels of fee-based assets.
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended Six Months Ended
-----------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, % Increase
(in thousands) 2007 2006 (Decrease) 2007 2006 (Decrease)
-----------------------------------------------------------------------------------------------------------------
Employee compensation and benefits $1,231,403 $1,220,216 0.9% $2,435,497 $ 2,267,066 7.4%
Floor brokerage, exchange and
clearance fees 63,907 58,621 9.0% 119,992 109,864 9.2%
Communications and technology 142,850 118,169 20.9% 270,758 222,203 21.9%
Occupancy 63,870 45,422 40.6% 120,615 90,049 33.9%
Advertising and market development 48,756 35,093 38.9% 85,829 69,766 23.0%
Professional fees 89,297 65,468 36.4% 161,163 119,341 35.0%
Impairment of goodwill and
specialist rights 227,457 - nm 227,457 - nm
Other expenses 90,779 122,254 (25.7%) 183,574 219,804 (16.5%)
-----------------------------------------------------------------------------------------------------------------
Total non-interest expenses $1,958,319 $1,665,243 17.6% $3,604,885 $ 3,098,093 16.4%
=================================================================================================================
nm - not meaningful
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Employee compensation and benefits includes the cost of salaries, benefits and
incentive compensation, including Capital Accumulation Plan ("CAP Plan") units,
restricted stock units and option awards. Employee compensation and benefits
increased 0.9% to $1.23 billion for the 2007 quarter from $1.22 billion for the
2006 quarter, and increased 7.4% to $2.44 billion for the six months ended May
31, 2007 from $2.27 billion for the six months ended May 31, 2006, primarily due
to higher discretionary compensation associated with the increase in net
revenues and increased head-count, reflecting the growth of the Company both
domestically and internationally. Employee compensation and benefits as a
percentage of net revenues increased to 49.0% for the 2007 quarter from 48.8%
for the 2006 quarter, and increased to 48.8% for the six months ended May 31,
2007 from 48.4% for the six months ended May 31, 2006. Full-time employees
increased to 15,120 at May 31, 2007 from 12,519 at May 31, 2006. The growth in
headcount is primarily due to increased business activities and growth
initiatives, both domestically and internationally.
Non-compensation expenses increased 63.3% to $726.9 million for the 2007 quarter
from $445.0 million for the 2006 quarter and increased 40.7% to $1.17 billion
for the six months ended May 31, 2007 from $831.0 million for the six months
ended May 31, 2006. Non-compensation expenses as a percentage of net revenues
increased to 28.9% for the 2007 quarter compared with 17.8% for the 2006
quarter, and increased to 23.4% for the six months ended May 31, 2007 compared
with 17.7% for the six months ended May 31, 2006. Included in the 2007 quarter
and 2007 six month results was a non-cash charge of $227.5 million related to
the write-off of intangible assets, representing goodwill and specialist rights,
associated with our NYSE specialist activities. Non-compensation expenses,
excluding the non-cash charge, were $509.4 million and $951.9 million for the
three and six months ended May 31, 2007, respectively. Communications and
technology costs increased 20.9% and 21.9% for the three and six months ended
May 31, 2007, respectively, compared with the corresponding prior year periods,
as increased head-count resulted in higher voice and market data-related costs
and higher information technology consulting expenses. Occupancy costs increased
40.6% and 33.9% for the three and six months ended May 31, 2007, respectively,
compared with the corresponding prior year periods, reflecting additional office
space requirements and higher leasing costs associated with the Company's
headquarters building at 383 Madison Avenue in New York City. Advertising and
market development costs increased 38.9% and 23.0% for the three and six months
ended May 31, 2007, respectively, compared with the corresponding prior year
periods, due to higher levels of client and deal related expenses. Professional
fees increased 36.4% and 35.0% for the three and six months ended May 31, 2007,
respectively, compared with the corresponding prior year periods, due to higher
levels of non-information technology consulting fees and employment agency fees.
Other expenses decreased 25.7% and 16.5% for the three and six months ended May
31, 2007, respectively, compared with the corresponding prior year periods,
primarily reflecting a reduction in litigation related costs. In addition, CAP
Plan related costs decreased 25.3% to $31.8 million for the 2007 quarter from
$42.5 million in the 2006 quarter, and decreased 6.7% to $73.3 million for the
six months ended May 31, 2007 from $78.5 million for the six months ended May
31, 2006, reflecting the lower level of earnings. Pre-tax profit margin was
22.0% and 27.8% for the three and six months ended May 31, 2007, respectively,
versus 33.4% and 33.9% for the corresponding prior year periods. Excluding the
$227.5 million non-cash charge associated with the write-off of intangible
assets, pre-tax profit margin was 30.7% and 32.2% for the three and six months
ended May 31, 2007, respectively.
The Company's effective tax rate decreased slightly to 34.7% for the 2007
quarter from 35.4% for the 2006 quarter and increased from 33.7% in the February
2007 quarter. The Company's effective tax rate for the six months ended May 31,
2007 increased to 34.1% from 33.6% in the comparable prior year period. The
increase in the effective tax rate in the May 2007 quarter when compared to the
February 2007 quarter was principally attributable to a $22 million reduction in
the value of deferred tax assets associated with reductions in state and local
income tax rates enacted during the quarter.
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Business Segments
The remainder of "Results of Operations" is presented on a business segment
basis. The Company's three business segments--Capital Markets, Global Clearing
Services and Wealth Management--are analyzed separately due to the distinct
nature of the products they provide and the clients they serve. Certain Capital
Markets products are distributed by the Wealth Management and Global Clearing
Services distribution networks, with the related revenues of such intersegment
services allocated to the respective segments. See Note 13, "Segment Data" in
the Notes to Condensed Consolidated Financial Statements for complete segment
information.
Capital Markets
---------------
Three Months Ended Six Months Ended
----------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, % Increase
(in thousands) 2007 2006 (Decrease) 2007 2006 (Decrease)
-----------------------------------------------------------------------------------------------------------------
Net revenues
Institutional equities $ 542,685 $ 560,496 (3.2%) $1,055,338 $ 1,060,389 (0.5%)
Fixed income 962,287 1,222,537 (21.3%) 2,111,639 2,129,675 (0.8%)
Investment banking 356,861 278,259 28.2% 659,970 573,809 15.0%
----------------------------------------------------------------------------------------------------------------
Total net revenues $1,861,833 $2,061,292 (9.7%) $3,826,947 $ 3,763,873 1.7%
Pre-tax income $ 376,927 $ 759,391 (50.4%) $1,113,238 $ 1,411,718 (21.1%)
----------------------------------------------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Capital Markets segment comprises institutional equities, fixed income and
investment banking. The Capital Markets segment operates as a single integrated
unit that provides the sales, trading and origination effort for various fixed
income, equity and advisory products and services to institutional and corporate
clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, over-the-counter equities,
equity derivatives, energy and commodity activities, risk and convertible
arbitrage and specialist activities on the NYSE, American Stock Exchange
("AMEX") and International Securities Exchange ("ISE"). Fixed income includes
sales, trading, origination and research provided to institutional clients
across a variety of products such as mortgage- and asset-backed securities,
corporate and government bonds, municipal bonds, high yield products, including
bank and bridge loans, foreign exchange and interest rate and credit
derivatives. Investment banking provides services in capital raising, strategic
advice, mergers and acquisitions and merchant banking. Capital raising
encompasses the Company's underwriting of equity, investment grade, municipal
and high yield debt products.
Net revenues for Capital Markets decreased 9.7% to $1.86 billion for the 2007
quarter compared with $2.06 billion for the 2006 quarter. Pre-tax income in the
2007 quarter reflects a $227.5 million impairment charge to goodwill and
specialist rights associated with NYSE specialist activities.
Institutional equities net revenues for the 2007 quarter decreased 3.2% to
$542.7 million from $560.5 million for the comparable prior year quarter. NYSE
specialist activities decreased significantly compared to the 2006 quarter, due
to the implementation of the NYSE Hybrid system. Energy related revenues also
decreased as the 2006 quarter included significant gains from the sale of
certain commodity assets. The 2006 quarter ended May 31, 2006 results also
reflect gains associated with the IPO of the NYSE. Substantially offsetting
these decreases were record net revenues in structured equity products, on
favorable market conditions, as well as record net revenues in risk arbitrage,
reflecting higher announced global M&A volumes.
Fixed income net revenues decreased 21.3% to $962.3 million for the 2007 quarter
from $1.22 billion for the comparable prior year quarter primarily due to a
decrease in mortgage-related revenues. Secondary trading revenues decreased in
the 2007 quarter compared with the 2006 quarter, particularly non-agency fixed
rate whole loans and Adjustable-Rate Mortgages ("ARMs"), reflecting the
challenges associated with the sub-prime mortgage sector. Partially offsetting
these decreases were increases in primary revenues from commercial
mortgage-backed securities and non-agency fixed rate whole loans. In addition,
interest rate derivatives and foreign exchange revenues decreased, reflecting
reduced global volatility and lower
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
customer volumes. Distressed trading revenues also decreased due to less
favorable market conditions. Partially offsetting these decreases were strong
results from structured credit trading and leveraged finance, as acquisition
related finance activity increased and customer activity levels remained high.
Investment banking revenues increased 28.2% to $356.9 million for the 2007
quarter from $278.3 million for the 2006 quarter. Underwriting revenues
increased 31.1% to $195.7 million for the 2007 quarter from $149.3 million for
the 2006 quarter. Equity underwriting revenues increased, reflecting higher
volumes of lead and co-managed IPOs and follow-on offerings as a result of
improved global equity market conditions. High yield underwriting revenues also
increased, reflecting increased new issue volumes. These increases were
partially offset by a decrease in high grade underwriting. Advisory and other
fees for the 2007 quarter increased 6.8% to $142.6 million from $133.5 million
for the prior year quarter reflecting increased M&A fees due to an increase in
customer activity. Merchant banking revenues increased to $18.6 million in the
2007 quarter from a loss of $4.5 million during the 2006 quarter, reflecting
gains on the Company's portfolio of investments and higher performance fees on
managed merchant banking funds.
Net revenues for Capital Markets increased 1.7% to $3.83 billion for the six
months ended May 31, 2007 compared to $3.76 billion for the 2006 period. Pre-tax
income in the 2007 period reflects a $227.5 million impairment charge to
goodwill and specialist rights.
Institutional equities net revenues for the 2007 period decreased slightly by
0.5% to $1.06 billion from the comparable prior year period. Revenues from the
Company's specialist activities and energy and commodity activities decreased in
the 2007 period. The 2006 period included gains on the sale of certain commodity
assets as well as gains associated with the IPO of the NYSE. Substantially
offsetting these decreases were increases in revenues from structured equity
products and risk arbitrage. In addition, revenues from the Company's
international equity sales and trading area rose, reflecting strength in
European and Asian equities.
Fixed income net revenues decreased 0.8% to $2.11 billion for the 2007 period
from $2.13 billion for the comparable prior year period. Mortgage-backed
securities revenues decreased in the 2007 period, when compared to the prior
year period due to weaker U.S. mortgage markets and challenges associated with
the sub-prime mortgage sector. Secondary trading revenues, particularly
non-agency fixed rate whole loans and ARMs decreased significantly in the 2007
period compared with the 2006 period. Primary revenues from commercial
mortgage-backed securities, collateralized mortgage obligations ("CMOs"), and
non-agency fixed rate whole loans increased during the 2007 period.
Substantially offsetting the decrease in mortgage-related revenues were
increases in the Company's credit businesses, particularly credit derivatives,
distressed trading and leveraged finance, which increases were due to increased
customer activity and favorable market conditions.
Investment banking revenues increased 15.0% to $660.0 million for the 2007
period from $573.8 million for the 2006 period. Underwriting revenues increased
28.9% to $367.9 million for the 2007 period from $285.5 million for the
corresponding prior year period, as equity underwriting revenues increased,
reflecting higher volumes of lead and co-managed IPOs and follow-on offerings as
a result of improved global equity market conditions. Additionally, high yield
and high grade underwriting revenues increased due to higher new issue volumes.
Advisory and other fees for the 2007 period increased 8.3% to $239.8 million
from $221.4 million for the 2006 period, reflecting an increase in M&A fees due
to increased customer activity. Merchant banking revenues decreased to $52.3
million in the 2007 period from $67.0 million during the 2006 period, reflecting
lower gains on the Company's portfolio of investments and lower performance fees
on managed merchant banking funds, which occurred in the first fiscal quarter of
2007.
Global Clearing Services
Three Months Ended Six Months Ended
-------------------------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands) 2007 2006 % Increase 2007 2006 % Increase
-------------------------------------------------------------------------------------------------------------------
Net revenues $ 316,785 $ 287,171 10.3% $ 592,343 $ 550,596 7.6%
Pre-tax income $ 154,751 $ 136,411 13.4% $ 267,551 $ 261,270 2.4%
-------------------------------------------------------------------------------------------------------------------
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
managers, short sellers, arbitrageurs and other professional investors. Fully
disclosed clients engage in either the retail or institutional brokerage
business. At May 31, 2007 and 2006, the Company held approximately $326.0
billion and $269.2 billion, respectively, in equity in Global Clearing Services
client accounts.
Net revenues for Global Clearing Services increased 10.3% to $316.8 million for
the 2007 quarter from $287.2 million in the 2006 quarter and increased 7.6% to
$592.3 million for the six months ended May 31, 2007 from $550.6 million in the
2006 period. Net interest revenues increased 18.6% to $246.8 million for the
2007 quarter from $208.2 million for the 2006 quarter and increased 13.0% to
$459.0 million for the six months ended May 31, 2007 from $406.1 million for the
prior year period, on higher average customer margin debt balances and customer
short balances. Commissions and other revenues decreased 11.4% to $70.0 million
for the 2007 quarter from $79.0 million for the 2006 quarter and decreased 7.7%
to $133.3 million for the six months ended May 31, 2007 from $144.5 million for
the 2006 period, reflecting lower average rates from prime brokerage clients as
well as lower trading volumes from fully-disclosed clients. Pre-tax income
increased 13.4% to $154.8 million for the 2007 quarter from $136.4 million for
the 2006 quarter and increased 2.4% to $267.6 million for the six months ended
May 31, 2007 from $261.3 million for the 2006 period. Pre-tax profit margin was
48.9% for the 2007 quarter compared with 47.5% for the 2006 quarter and 45.2%
for the six months ended May 31, 2007 compared with 47.5% for the 2006 period.
The following table presents the Company's interest-bearing balances for the
fiscal periods ended:
Three Months ended Six Months ended
--------------------------------------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in billions) 2007 2006 2007 2006
--------------------------------------------------------------------------------------------
Margin debt balances, average for period $ 95.4 $ 68.4 $ 88.3 $ 66.5
Margin debt balances, at period end 108.4 72.7 108.4 72.7
Customer short balances, average for period 101.9 80.2 97.9 79.2
Customer short balances, at period end 109.0 81.7 109.0 81.7
Securities borrowed, average for period 66.6 54.8 63.3 53.9
Securities borrowed, at period end 65.4 52.1 65.4 52.1
Free credit balances, average for period 38.0 30.8 35.9 30.4
Free credit balances, at period end 36.4 34.1 36.4 34.1
Equity held in client accounts, at period
end 326.0 269.2 326.0 269.2
--------------------------------------------------------------------------------------------
Wealth Management
-----------------
Three Months Ended Six Months Ended
----------------------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands) 2007 2006 % Increase 2007 2006 % Increase
------------------------------------------------------------------------------------------------------------------
Private client services revenues $ 185,082 $ 154,184 20.0% $ 350,671 $ 308,079 13.8%
Revenue transferred to Capital
Markets segment (27,816) (24,125) 15.3% (57,252) (48,409) 18.3%
-----------------------------------------------------------------------------
Private client services net
revenues 157,266 130,059 20.9% 293,419 259,670 13.0%
Asset management 184,114 22,999 700.5% 303,273 118,075 156.8%
-----------------------------------------------------------------------------
Total net revenues $ 341,380 $ 153,058 123.0% $ 596,692 $ 377,745 58.0%
Pre-tax income $ 56,465 $ (11,801) nm $ 100,218 $ 19,985 401.5%
-----------------------------------------------------------------------------------------------------------------
nm - not meaningful
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
The Wealth Management segment is composed of the PCS and asset management areas.
PCS provides high-net-worth individuals with an institutional level of
investment service, including access to the Company's resources and
professionals. At May 31, 2007, PCS had approximately 500 account executives in
its principal office, six regional offices and two international offices. Asset
management manages equity, fixed income and alternative assets for corporate
pension plans, public systems, endowments, foundations, multi-employer plans,
insurance companies, corporations, families and high-net-worth individuals in
the United States and abroad.
43
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net revenues for Wealth Management increased 123.0% to $341.4 million for the
2007 quarter from $153.1 million for the 2006 quarter and increased 58.0% to
$596.7 million for the six months ended May 31, 2007 from $377.7 million for the
2006 period. Asset management revenues increased 700.5% to $184.1 million for
the 2007 quarter from $23.0 million for the 2006 quarter and increased 156.8% to
$303.3 million for the six months ended May 31, 2007 from $118.1 million for the
2006 period, primarily reflecting growth in performance fees on proprietary
hedge fund products as well as improved investment returns on proprietary
investments and growth in management fees on higher levels of traditional and
alternative assets under management. PCS net revenues increased 20.9% to $157.3
million for the 2007 quarter from $130.1 million for the 2006 quarter and
increased 13.0% to $293.4 million for the six months ended May 31, 2007 from
$259.7 million for the 2006 period, reflecting higher levels of fee-based income
attributable to the Company's private client advisory services products.
Assets under management were $59.8 billion at May 31, 2007, reflecting a 24.8%
increase from $47.9 billion in assets under management at May 31, 2006. The
increase in assets under management is due to the growth in traditional equity
assets and alternative products, attributable to both market appreciation and
net inflows. Assets under management at May 31, 2007 include $10.2 billion of
assets from alternative investment products, an increase from $6.8 billion at
May 31, 2006.
LIQUIDITY AND CAPITAL RESOURCES
Financial Leverage
------------------
Asset Composition
The Company's actual level of capital, capital requirements and thereby the
level of financial leverage, is a function of numerous variables, including
asset composition, rating agency/creditor perception, business prospects,
regulatory requirements, balance sheet liquidity, cost/availability of capital
and risk of loss. The Company consistently maintains a highly liquid balance
sheet, with the vast majority of the Company's assets consisting of cash,
marketable securities inventories and collateralized receivables arising from
customer-related and proprietary securities transactions.
Collateralized receivables consist of resale agreements secured predominantly by
U.S. government and agency securities, customer margin loans and securities
borrowed, which are typically secured by marketable corporate debt and equity
securities. The nature of the Company's business as a securities dealer requires
it to carry significant levels of securities inventories to meet its customer
and proprietary trading needs. Additionally, the Company's role as a financial
intermediary for customer activities, which it conducts on a principal basis,
together with its customer-related activities in its clearance business, results
in significant levels of customer-related balances, including customer margin
debt, securities borrowed and reverse repurchase activity. The Company's total
assets and financial leverage can and do fluctuate, depending largely on
economic and market conditions, volume of activity and customer demand.
The Company's total assets at May 31, 2007 increased to $423.3 billion from
$350.4 billion at November 30, 2006. The increase was primarily attributable to
increases in financial instruments owned, at fair value, assets of variable
interest entities and mortgage loan special purpose entities, securities
borrowed, and customer receivables partially offset by a decrease in cash and
securities deposited with clearing organizations or segregated in compliance
with federal regulations. The Company's total capital base, which consists of
long-term debt and total stockholders' equity, increased to $75.1 billion at May
31, 2007 from $66.7 billion at November 30, 2006. This change was primarily due
to a net increase in long-term debt and an increase in stockholders' equity
primarily due to earnings in the 2007 period and stock-based grants to
employees, as well as income tax benefits attributable to the distribution of
common stock under the Company's deferred compensation plans.
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's total capital base as of May 31, 2007 and November 30, 2006 was as
follows:
May 31, November 30,
(in millions) 2007 2006
----------------------------------------------------------
Long-term borrowings:
Senior debt $ 60,527.8 $ 53,307.4
Subordinated debt (1) 1,262.5 1,262.5
----------------------------------------------------------
Total long-term borrowings $ 61,790.3 $ 54,569.9
Stockholders' equity:
Preferred stockholders' equity $ 359.2 $ 359.2
Common stockholders' equity 12,948.9 11,770.2
----------------------------------------------------------
Total stockholders' equity $ 13,308.1 $ 12,129.4
----------------------------------------------------------
Total capital $ 75,098.4 $ 66,699.3
==========================================================
(1) Includes $1.0 billion in subordinated debt issued by the Company and $262.5
million in junior subordinated deferrable interest debentures ("Debentures")
issued by the Company and held by Bear Stearns Capital Trust III ("Capital Trust
III") at May 31, 2007 and November 30, 2006.
The amount of long-term debt as well as total capital that the Company maintains
is driven by a number of factors, with particular focus on asset composition.
The Company's ability to support increases in total assets is a function of its
ability to obtain short-term secured and unsecured funding, as well as its
access to longer-term sources of capital (i.e., long-term debt and equity). The
Company regularly measures and monitors its total capital requirements, which
are primarily a function of the self-funding ability of its assets. The equity
portion of total capital is primarily a function of on- and off-balance-sheet
risks (i.e., market, credit and liquidity) and regulatory capital requirements.
As such, the liquidity and risk characteristics of assets being held are
critical determinants of both total capital and the equity portion thereof, thus
significantly influencing the amount of leverage that the Company can employ.
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at each quarter end are typically lower than would be
observed on an average basis. At the end of each quarter, the Company typically
uses excess cash to finance high-quality, highly liquid securities inventory
that otherwise would be funded via the repurchase agreement market. In addition,
the Company reduces its matched book repurchase and reverse repurchase
activities at quarter end. Finally, the Company may reduce the aggregate level
of inventories through ordinary course, open market activities in the most
liquid portions of the balance sheet, which are principally U.S. government and
agency securities and agency mortgage pass-through securities. At May 31, 2007,
total assets of $423.3 billion were approximately 4.5% higher than the average
of the month-end balances observed over the trailing 12-month period, while
total assets at November 30, 2006 were approximately 0.5% higher than the
average of the month-end balances over the trailing 12-months prior. Despite
reduced total assets at each quarter end, the Company's overall market, credit
and liquidity risk profile does not change materially, since the reduction in
asset balances is predominantly in highly liquid, short-term instruments that
are financed on a secured basis. This periodic reduction verifies the inherently
liquid nature of the balance sheet and provides consistency with respect to
creditor constituents' evaluation of the Company's financial condition.
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of a securities firm, such as the Company. Gross leverage equals total
assets divided by stockholders' equity, inclusive of preferred and trust
preferred equity. The Company views its trust preferred equity as a component of
its equity capital base given the equity-like characteristics of the securities.
The Company also receives rating agency equity credit for these securities. Net
adjusted leverage equals net adjusted assets divided by tangible equity capital,
which excludes goodwill and intangible assets from both the numerator and the
denominator, as equity used to support goodwill and intangible assets is not
available to support the balance of the Company's net assets. With respect to a
comparative measure of financial risk and capital adequacy, the Company believes
that the low-risk nature of the items excluded in deriving net adjusted assets
(see table) renders net adjusted leverage as the more relevant measure.
(in millions, except ratios) May 31, 2007 November 30, 2006
-----------------------------------------------------------------------------------------
Total assets $ 423,304 $ 350,433
Deduct:
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations 4,653 8,804
Securities purchased under agreements to
resell 42,272 38,838
Securities received as collateral 18,948 19,648
Securities borrowed 92,050 80,523
Receivables from customers 41,344 29,482
Assets of variable interest entities and
Mortgage loan special purpose entities, net 47,923 29,080
Goodwill & intangible assets 93 383
-----------------------------------------------------------------------------------------
Subtotal 176,021 143,675
-----------------------------------------------------------------------------------------
Add:
Financial instruments sold, but not yet
purchased, at fair value 46,350 42,256
Deduct:
Derivative financial instruments 12,816 11,865
-------------------------------------------------------------------------------------------
Net adjusted assets $ 209,555 $ 174,066
===========================================================================================
Stockholders' equity
Common equity $ 12,949 $ 11,770
Preferred stock 359 359
Stock-based compensation - 816(1)
-------------------------------------------------------------------------------------------
Total stockholders' equity 13,308 12,945
-------------------------------------------------------------------------------------------
Add:
Trust preferred equity 263 263
-------------------------------------------------------------------------------------------
Subtotal - leverage equity 13,571 13,208
-------------------------------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 93 383
-------------------------------------------------------------------------------------------
Tangible equity capital $ 13,478 $ 12,825
===========================================================================================
Gross leverage 31.2 26.5
Net adjusted leverage 15.5 13.6
-------------------------------------------------------------------------------------------
(1) Represents stock-based compensation associated with fiscal 2006 awards that
was reflected in stockholders' equity as of the grant date in December 2006, in
accordance with SFAS No. 123(R), "Share-based Payment." Excluding this
adjustment for stock-based compensation, gross leverage and net adjusted
leverage at November 30, 2006 would have been 28.3 and 14.5, respectively.
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Funding Strategy & Liquidity Risk Management
--------------------------------------------
General Funding Strategy
Liquidity is extraordinarily important for financial services firms in general
and for securities firms such as the Company in particular, given their reliance
on market confidence. The Company's overall objective and general funding
strategy seeks to ensure liquidity and diversity of funding sources to meet the
Company's financing needs at all times and under all market environments. In
financing its balance sheet, the Company attempts to maximize its use of secured
funding. Short-term sources of cash consist principally of collateralized
borrowings, including repurchase transactions, sell/buy arrangements, securities
lending arrangements and customer short balances. Short-term unsecured funding
sources expose the Company to rollover risk, as providers of credit are not
obligated to refinance the instruments at maturity. For this reason, the Company
seeks to prudently manage its reliance on short-term unsecured borrowings by
maintaining an adequate total capital base in combination with extensive use of
secured funding and the maintenance of a liquidity pool at the parent company
("Parent Company Liquidity Pool"). In addition to this strategy, the Company
places emphasis on diversification by product, geography, maturity and
instrument in order to further ensure prudent, moderate usage of more
credit-sensitive, potentially less stable, funding. Short-term unsecured funding
sources include commercial paper, medium-term notes and bank borrowings, which
generally have maturities ranging from overnight to one year. The Company views
its secured funding as inherently less credit sensitive and therefore a more
stable source of funding due to the collateralized nature of the borrowing.
In addition to short-term funding sources, the Company utilizes equity and
long-term debt, including floating- and fixed-rate notes, as longer-term sources
of unsecured financing. The Company regularly monitors and analyzes the size,
composition and liquidity characteristics of its asset base in the context of
each asset's ability to be used to obtain secured financing. This analysis helps
the Company in determining its aggregate need for longer-term funding sources
(i.e., long-term debt and equity). The Company views long-term debt as a stable
source of funding, which effectively strengthens its overall liquidity profile
and mitigates liquidity risk.
Alternative Funding Strategy
The Company maintains an alternative funding strategy focused on the liquidity
and self-funding ability of the underlying assets. The objective of this
strategy is to maintain sufficient cash capital (i.e., equity plus long-term
debt maturing in more than 12 months) and funding sources to enable the Company
to refinance short-term, unsecured borrowings with fully secured borrowings. As
such, the Company is not reliant upon nor does it contemplate forced balance
sheet reduction to endure a period of constrained funding availability. This
underlying approach is supported by maintenance of a formal contingency funding
plan, which includes a detailed delegation of authority and precise action steps
for managing an event-driven liquidity crisis. The plan identifies the crisis
management team, details an effective internal and external communication
strategy, and facilitates the greater information flow required to effect a
rapid and efficient transition to a secured funding environment.
As it relates to the alternative funding strategy discussed above, the Company
prepares an analysis that focuses on a 12-month time period and assumes that the
Company does not liquidate assets and cannot issue any new unsecured debt,
including commercial paper. Under these assumptions, the Company monitors its
cash position, Parent Company Liquidity Pool and the borrowing value of
unencumbered, unhypothecated financial instruments in relation to its unsecured
debt maturing over the next 12 months, striving to maintain the ratio of
liquidity sources to maturing debt at 110% or greater. Also within this
strategy, the Company seeks to maintain cash capital in excess of that portion
of its assets that cannot be funded on a secured basis (i.e., positive net cash
capital). These two measures, liquidity ratio and net cash capital, are
complementary and constitute the core elements of the Company's alternative
funding strategy and, consequently, its approach to funding and liquidity risk
management.
The borrowing value advance rates used in the Company's liquidity ratio
calculation and the haircuts incorporated in the cash capital model are
symmetrical. These advance rates are considered readily available, even in a
stress environment. In the vast majority of circumstances/asset classes, advance
rates are derived from committed secured bank facilities, whereby a bank or
group of banks are contractually obligated to lend to the Company at a
pre-specified advance rate on specific types of collateral regardless of "market
environment." As such, the advance rates/haircuts in the alternative liquidity
models are typically worse than those the Company realizes in normalized repo
and secured lending markets. The advance rates in the liquidity ratio reflect
what can be reliably realized in a stressed liquidity environment. The haircuts
used in the cash capital model are consistent with the advance rates used in the
liquidity ratio in that the haircut is equal to one minus the advance rate.
47
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
As of May 31, 2007, the market value of unencumbered, unhypothecated financial
instruments owned by the Company was approximately $35.2 billion with a
borrowing value of $27.1 billion. The assets are primarily comprised of
mortgage- and asset-backed securities, investment grade municipal and corporate
bonds, U.S. equities and residential and commercial mortgage whole loans. The
average advance rate on these different asset types ranges from 55% to 95% and,
as described above, is based predominantly on committed, secured facilities that
the Company and its subsidiaries maintain in different regions globally. The
liquidity ratio, explained above, based solely on Company-owned securities, has
averaged 138% over the previous seven months of fiscal 2007 (inclusive of
November 2006), including the Company's $4.0 billion unused committed unsecured
bank credit, and 127%, excluding the committed unsecured revolving credit
facility. On this same basis, the liquidity ratio as of May 31, 2007 was 155%
and 139%, respectively.
While The Bear Stearns Companies Inc. ("Parent Company") is the primary issuer
of unsecured debt in the marketplace, the collateral referred to in the
preceding paragraph is held in various subsidiaries, both regulated and
unregulated. A subsidiary's legal entity status and the Company's intercompany
funding structure may constrain liquidity available to the Parent Company, as
regulators may prevent the flow of funds and/or securities from a regulated
subsidiary to its parent company or other subsidiaries. In recognition of this
potential for liquidity to be trapped in subsidiaries, the Company maintains a
minimum of $5.0 billion of liquidity immediately accessible by the Parent
Company at all times. This liquidity pool can take the form of cash deposits and
money market instruments that are held at the Parent Company level and
high-quality collateral (corporate bonds, municipal bonds, equity securities)
that is owned by subsidiaries and explicitly pledged to and segregated for the
benefit of the Parent Company and maintained at a third-party custodian. For
purposes of calculating the aggregate value of the Parent Company Liquidity
Pool, the contractually obligated advance rates described herein are used to
determine the borrowing value of collateral pledged. As of May 31, 2007 the
Parent Company Liquidity Pool was $7.6 billion comprised entirely of short term
money funds, bank deposits and short term high quality money market investments.
The Parent Company Liquidity Pool was $11.3 billion at the end of June 2007. In
addition to this immediately available liquidity, the Company monitors
unrestricted liquidity available to the Parent Company via the ability to
monetize unencumbered assets held in unregulated and regulated entities. As of
May 31, 2007, approximately $26.3 billion of the market value identified in the
liquidity ratio data above was held in unregulated entities and thus likely to
be available to the Parent Company. The remaining $8.9 billion market value of
unencumbered securities was held in regulated entities, a portion of which may
not be available to provide liquidity to the Parent Company.
The cash capital framework is utilized to evaluate the Company's long-term
funding sources and requirements in their entirety. Cash capital required to
support all of the Company's assets is determined on a regular basis. For
purposes of broadly classifying the drivers of cash capital requirements, cash
capital usage can be delineated across two very broad categories as (1) firmwide
haircuts and (2) illiquid assets/long-term investments. More precisely, the
Company holds cash capital to support longer-term funding requirements,
including, but not limited to, the following:
o That portion of financial instruments owned that cannot be funded on a
secured basis (i.e., the haircuts);
o Margin loans and resale principal in excess of the borrowing value of
collateral received;
o Operational cash deposits required to support the regular activities of
the Company (e.g., exchange initial margin);
o Unfunded committed funding obligations, such as corporate loan
commitments;
o Less liquid and illiquid assets, such as mutual funds, restricted
securities and fixed assets;
o Uncollateralized funded loans and funded loans secured by illiquid and/or
non-rehypothecatable collateral;
o Merchant banking assets and other long-term investments; and
o Regulatory capital in excess of a regulated entity's cash capital based
longer-term funding requirements.
At May 31, 2007, the Company's net cash capital position was $2.9 billion.
Fluctuations in net cash capital are common and are a function of variability in
total assets, balance sheet composition and total capital. The Company attempts
to maintain cash capital sources in excess of the aggregate longer-term funding
requirements of the firm with a recently established target for positive net
cash capital of $2.0 billion. Over the previous seven months of fiscal year 2007
(inclusive of November 2006), the Company's total cash capital requirement, cash
capital intensity ratio (average haircut), and net cash capital position have
averaged $64.8 billion, 16.6% and $913 million, respectively.
In addition to the alternative funding measures above, the Company monitors the
maturity profile of its unsecured debt to minimize refinancing risk, maintains
relationships with a broad global base of debt investors and bank creditors,
establishes and adheres to strict short-term debt investor concentration limits,
and periodically tests its secured and unsecured committed credit facilities. An
important component of the Company's funding and liquidity risk management
efforts involves ongoing dialogues with a large number of creditor constituents.
Strong relationships with a diverse base of creditors and debt investors are
crucial to the Company's liquidity. The Company also maintains available sources
of short-term funding that exceed
48
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
actual utilization, thus allowing it to endure changes in investor appetite and
credit capacity to hold the Company's debt obligations.
With respect to the management of refinancing risk, the maturity profile of the
long-term debt portfolio of the Company is monitored on an ongoing basis and
structured within the context of two diversification guidelines. The Company has
a general guideline of no more than 20% of its long-term debt portfolio maturing
in any one year, as well as no more than 10% maturing in any one quarter over
the next five years. The Company continued to meet these guidelines at the end
of the quarter ended May 31, 2007. As of May 31, 2007, the weighted average
maturity of the Company's long-term debt was 4.3 years.
Committed Credit Facilities
The Company has a committed revolving credit facility ("Facility") totaling $4.0
billion, which permits borrowing on a secured basis by the Parent Company, BSSC,
BSIL and certain other subsidiaries. The Facility also allows the Parent
Company, BSIL and Bear Stearns International Trading Limited ("BSIT") to borrow
up to $4.0 billion of the Facility on an unsecured basis. Secured borrowings can
be collateralized by both investment-grade and non-investment-grade financial
instruments as the Facility provides for defined advance rates on a wide range
of financial instruments eligible to be pledged. The Facility contains financial
covenants, the most significant of which require maintenance of specified levels
of stockholders' equity of the Company and net capital of BSSC. The Facility
terminates in February 2008, with all loans outstanding at that date payable no
later than February 2009. There were no borrowings outstanding under the
Facility at May 31, 2007.
The Company has a $1.5 billion committed revolving securities repo facility
("Repo Facility"), which permits borrowings secured by a broad range of
collateral under a repurchase arrangement by the Parent Company, BSIL, BSIT and
BSB. The Repo Facility contains financial covenants that require, among other
things, maintenance of specified levels of stockholders' equity of the Company.
The Repo Facility terminates in August 2007, with all repos outstanding at that
date payable no later than August 2008. There were no borrowings outstanding
under the Repo Facility at May 31, 2007.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC, Bear Stearns Japan Limited ("BSJL"), and BSIL. The Pan Asian Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company and net capital of BSSC.
The Pan Asian Facility terminates in December 2007 with all loans outstanding at
that date payable no later than December 2008. There were no borrowings
outstanding under the Pan Asian Facility at May 31, 2007.
The Company has a $450 million committed revolving credit facility ("Tax Lien
Facility"), which permits borrowing on a secured basis by the Parent Company,
Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax Lien Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. The Tax Lien Facility
terminates in March 2008 with all loans outstanding at that date payable no
later than March 2009. There were no borrowings outstanding under the Tax Lien
Facility at May 31, 2007.
The Company also maintains a series of committed credit facilities, which permit
borrowing on a secured basis, to support liquidity needs for the financing of
investment-grade and non-investment-grade corporate loans, residential
mortgages, commercial mortgages, listed options and auto loans. The facilities
are expected to be drawn from time to time and expire at various dates, the
longest of such periods ending in fiscal 2009. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $6.4 billion. At May 31, 2007, the borrowings outstanding under
these committed credit facilities were $1.2 billion.
Capital Resources
-----------------
The Parent Company, operating as the centralized unsecured funding arm of the
Company, raises the vast majority of the Company's unsecured debt, including
both commercial paper and long-term debt. The Parent Company is thus the
"central bank" of the Company, where all capital is held and from which capital
is deployed. The Parent Company advances funds in the form of debt or equity to
subsidiaries to meet their operating funding needs and regulatory capital
requirements. In addition to the primary regulated subsidiaries, the Company
also conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited, Custodial Trust Company, Bear
Stearns Financial Products
49
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Inc., Bear Stearns Capital Markets Inc., Bear Stearns Credit Products Inc., Bear
Stearns Forex Inc., EMC Mortgage Corporation and Bear Stearns Commercial
Mortgage, Inc. and Bear Hunter Holdings LLC. In connection with all of the
Company's operating activities, a substantial portion of the Company's long-term
borrowings and equity has been used to fund investments in, and advances to,
these subsidiaries, including subordinated debt advances.
Within this funding framework, the Company attempts to fund equity investments
in subsidiaries with equity from the Parent Company (i.e., utilize no equity
double leverage). At May 31, 2007, the Parent Company's equity investment in
subsidiaries was $8.9 billion versus common stockholders' equity and preferred
equity of $12.9 billion and $359.2 million, respectively. As such, at May 31,
2007, the ratio of the equity investment in subsidiaries to Parent Company
equity (equity double leverage) was approximately 0.68 based on common equity
and 0.67 including preferred equity. At November 30, 2006, these measures were
0.67 based on common equity and 0.65 including preferred equity. Additionally,
all subordinated debt advances to regulated subsidiaries for use as regulatory
capital, which totaled $10.9 billion at May 31, 2007, are funded with long-term
debt issued by the Company, having a remaining maturity equal to or greater than
the maturity of the subordinated debt advance. The Company regularly monitors
the nature and significance of assets or activities conducted in all
subsidiaries and attempts to fund such assets with both capital and/or
borrowings having a maturity profile and relative mix consistent with the nature
and self-funding ability of the assets being financed. The funding mix also
takes into account regulatory capital requirements for regulated subsidiaries.
Long-term debt totaling $53.9 billion and $48.1 billion had remaining maturities
beyond one year at May 31, 2007 and November 30, 2006, respectively. The Company
accesses funding in a variety of markets in the United States, Europe and Asia.
The Company issues debt through syndicated U.S. registered offerings,
U.S.-registered and 144A medium-term note programs, other U.S. and non-U.S. bond
and note offerings and other methods. The Company's access to external sources
of financing, as well as the cost of that financing, is dependent on various
factors and could be adversely affected by a deterioration of the Company's
long- and short-term debt ratings, which are influenced by a number of factors.
These include, but are not limited to: material changes in operating margins;
earnings trends and volatility; the prudence of funding and liquidity management
practices; financial leverage on an absolute basis or relative to peers; the
composition of the balance sheet and/or capital structure; geographic and
business diversification; and the Company's market share and competitive
position in the business segments in which it operates. Material deterioration
in any one or a combination of these factors could result in a downgrade of the
Company's credit ratings, thus increasing the cost of and/or limiting the
availability of unsecured financing. Additionally, a reduction in the Company's
credit ratings could also trigger incremental collateral requirements,
predominantly in the over-the-counter derivatives market. As of May 31, 2007, a
downgrade by either Moody's Investors Service or Standard & Poor's in the
Company's long-term credit ratings to the level of A3 or A- (i.e., two notches)
would have resulted in the Company being required to post $56.3 million in
additional collateral pursuant to contractual arrangements for outstanding
over-the-counter derivatives contracts. A downgrade to Baa1 or BBB+ (i.e., three
notches) would have resulted in the Company being required to post an additional
$378.2 million in collateral.
At May 31, 2007, the Company's long-term/short-term debt ratings were as
follows:
Long-Term Rating Short-Term Rating
--------------------------------------------------------------------------------
Dominion Bond Rating Service Limited A(high) R-1 (middle)
Fitch Ratings A+ F1+
Japan Credit Rating Agency, Ltd. AA NR
Moody's Investors Service A1 P-1
Rating & Investment Information, Inc. AA- NR
Standard & Poor's Ratings Services A+ A-1
--------------------------------------------------------------------------------
NR - does not assign a short-term rating
In April 2007, Dominion Bond Rating Service Limited ("DBRS") changed the trend
on all long-term ratings of the Bear Stearns Companies Inc. to "Positive" from
"Stable". In a press release, DBRS stated that this change in trend reflects the
Company's success in broadening its franchise, international expansion, and
strong earnings power, while maintaining a strong financial profile and
conservative risk management.
In October 2006, Standard & Poor's Ratings Services ("S&P") upgraded The Bear
Stearns Companies Inc. long-term rating to A+. In a press release, S&P stated
that the rating change reflects the Company's relatively low profit volatility,
conservative management and cost flexibility, as well as long-term improvements
in its liquidity and risk management.
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In addition, in June 2006, Japan Credit Rating Agency, Ltd. assigned a rating of
AA with a "Stable" outlook to the Company, while in August 2006, Rating and
Investment Information, Inc. upgraded the Company to AA- from A+ with a "Stable"
outlook.
Stock Repurchase Program
------------------------
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of the annual grants by purchasing
common stock throughout the year in open market and private transactions.
The Company has two authorizations to purchase its common stock in fiscal 2007.
On December 13, 2006, the Board of Directors of the Company approved an
amendment to the Stock Repurchase Program ("Repurchase Program") to replenish
the previous authorizations to allow the Company to purchase up to $2.0 billion
of common stock in fiscal 2007 and beyond. During the quarter ended May 31,
2007, the Company purchased under the current authorization a total of 1,969,585
shares at a cost of approximately $297.3 million. Approximately $1.28 billion
was available to be purchased under the current authorization as of May 31,
2007. The Company may, depending on price and other factors, repurchase
additional shares in excess of that required for annual share awards.
Under the second stock repurchase authorization, during the quarter ended May
31, 2007, the Company purchased a total of 209,597 shares of its common stock at
a total cost of $31.8 million pursuant to a $200 million CAP Plan Earnings
Purchase Authorization, which was approved by the Compensation Committee of the
Board of Directors of the Company on December 12, 2006. Approximately $132.4
million was available to be purchased under the current authorization as of May
31, 2007.
Cash Flows
----------
Cash and cash equivalents increased $6.6 billion to $11.2 billion at May 31,
2007 from $4.6 billion at November 30, 2006. Cash provided by operating
activities was $2.3 billion, primarily attributable to the increase in
securities sold under agreements to repurchase, net of securities purchased
under agreements to resell, partially offset by the increase in financial
instruments owned, which occurred in the normal course of business as a result
of changes in customer needs, market conditions and trading strategies. Cash
used in investing activities of $147.4 million reflected purchases of property,
equipment and leasehold improvements. Cash provided by financing activities of
$4.5 billion reflected net proceeds from the issuance of long-term borrowings of
$13.0 billion and net proceeds relating to other secured borrowings of $5.8
billion, primarily to fund normal operating activities. This was partially
offset by net payments for unsecured short-term borrowings of $8.4 billion and
the retirement/repurchase of long-term borrowings of $5.4 billion. Treasury
stock purchases of $802.2 million were made to provide for the annual grant of
CAP Plan units, restricted stock and stock options.
Cash and cash equivalents increased $132.2 million to $6.0 billion at May 31,
2006 from $5.9 billion at November 30, 2005. Cash used in operating activities
was $15.2 billion, primarily attributable to increases in financial instruments
owned and securities borrowed, net of securities loaned, partially offset by an
increase in financial instruments sold, but not yet purchased and securities
sold under agreements to repurchase, net of securities purchased under
agreements to resell, which occurred in the normal course of business as a
result of changes in customer needs, market conditions and trading strategies.
Cash used in investing activities of $91.5 million reflected purchases of
property, equipment and leasehold improvements. Cash provided by financing
activities of $15.4 billion reflected net proceeds from unsecured short-term
borrowings of $9.0,
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
net proceeds from the issuance of long-term borrowings of $8.8 billion and net
proceeds relating to other secured borrowings of $3.9 billion, primarily to fund
normal operating activities. This was partially offset by payments for the
retirement/repurchase of long-term borrowings of $6.4 billion. Treasury stock
purchases of $529.6 million were made to provide for the annual grant of CAP
Plan units, RSUs and stock options.
Regulated Subsidiaries
----------------------
The Company is regulated by the SEC as a consolidated supervised entity ("CSE").
As a CSE, the Company is subject to group-wide supervision and examination by
the SEC and is required to compute allowable capital and allowances for market,
credit and operational risk on a consolidated basis. As of May 31, 2007, the
Company was in compliance with the CSE capital requirements.
As registered broker-dealers and futures commission merchants, Bear Stearns and
BSSC are subject to the net capital requirements of the Exchange Act and Rule
1.17 under the Commodity Futures Trading Commission. Bear Stearns uses Appendix
E of the Net Capital Rule which establishes alternative net capital requirements
for broker-dealers that are part of consolidated supervised entities. Appendix E
allows Bear Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models provided that Bear
Stearns holds tentative net capital in excess of $1 billion and net capital in
excess of $500 million. BSIL and BSIT, the Company's London-based broker-dealer
subsidiaries, are subject to the regulatory capital requirements of the United
Kingdom's Financial Services Authority. Additionally, BSB is subject to the
regulatory capital requirements of the Financial Regulator. Custodial Trust
Company ("CTC"), a Federal Deposit Insurance Corporation ("FDIC") insured New
Jersey state chartered bank, is subject to the regulatory capital requirements
of the FDIC. At May 31, 2007, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC were
in compliance with their respective regulatory capital requirements. Certain
other subsidiaries are subject to various securities regulations and capital
adequacy requirements promulgated by the regulatory and exchange authorities of
the countries in which they operate. At May 31, 2007, these other subsidiaries
were in compliance with their applicable local capital adequacy requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 10, "Regulatory
Requirements," in the Notes to Condensed Consolidated Financial Statements.
Merchant Banking and Private Equity Investments
-----------------------------------------------
In connection with the Company's merchant banking activities, the Company had
investments in merchant banking and private equity-related investment funds as
well as direct investments in private equity-related investments. At May 31,
2007, the Company held investments with an aggregate recorded fair value of
approximately $1.12 billion, reflected in the Condensed Consolidated Statements
of Financial Condition in "Other assets." At November 30, 2006, the Company held
investments with an aggregate recorded value of approximately $822.4 million. In
addition to these various direct and indirect principal investments, the Company
has made commitments to invest in private equity-related investments and
partnerships (see the summary table under "Commitments").
High Yield Positions
--------------------
As part of its fixed income activities, the Company participates in the
underwriting and trading of non-investment-grade corporate debt securities and
also invests in, syndicates and trades in loans to highly leveraged, below
investment grade rated companies (collectively, "high yield positions").
Non-investment-grade debt securities have been defined as non-investment-grade
corporate debt and emerging market debt rated BB+ or lower, or equivalent
ratings recognized by credit rating agencies. At May 31, 2007 and November 30,
2006, the Company held high yield positions approximating $9.5 billion and $10.7
billion, respectively, substantially all of which are in "Financial instruments
owned, at fair value" in the Condensed Consolidated Statements of Financial
Condition, and $675.3 million and $605.4 million, respectively, reflected in
"Financial instruments sold, but not yet purchased, at fair value" in the
Condensed Consolidated Statements of Financial Condition. Included in the high
yield positions are extensions of credit to highly leveraged companies. At May
31, 2007 and November 30, 2006, the amount outstanding to highly leveraged
borrowers totaled $5.8 billion and $7.7 billion, respectively. The largest
industry concentration to highly leveraged borrowers was the technology
industry, which approximated 21.2% and 22.8% of these highly leveraged
borrowers' positions at May 31, 2007 and November 30, 2006, respectively.
Additionally, the Company has lending commitments with highly leveraged
borrowers (see the summary table under "Commitments").
52
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's Risk Management Department and senior trading managers monitor
exposure to market and credit risk for high yield positions and establish limits
and concentrations of risk by individual issuer. High yield positions generally
involve greater risk than investment grade debt securities due to credit
considerations, liquidity of secondary trading markets and increased
vulnerability to changes in general economic conditions. The level of the
Company's high yield positions, and the impact of such activities on the
Company's results of operations, can fluctuate from period to period as a result
of customer demand, economic conditions and market considerations.
Contractual Obligations
-----------------------
In connection with its operating activities, the Company enters into contractual
obligations that require future cash payments. At May 31, 2007, the Company's
contractual obligations by maturity, excluding derivative financial instruments,
were as follows:
Payments Due By Period
--------------------------------------------------
Remaining Fiscal Fiscal
(in millions) Fiscal 2007 2008- 2009 2010- 2011 Thereafter Total
------------------------------------------------------------------------------------------------
Long-term borrowings (1)(2) $ 3,068 $ 21,624 $ 15,977 $ 21,121 $ 61,790
Future minimum lease payments (3)(4) 54 254 241 747 1,296
------------------------------------------------------------------------------------------------
(1) Amounts include hybrid debt issuances accounted for at fair value as
elected under SFAS No. 155 and fair value adjustments in accordance with
SFAS No. 133 as well as $262.5 million of junior subordinated deferrable
interest debentures ("Debentures"). The Debentures will mature on May 15,
2031; however, the Company, at its option, may redeem the Debentures
beginning May 15, 2006. The Debentures are reflected in the table at their
contractual maturity dates.
(2) Included in fiscal 2008-2009 are approximately $1.83 billion of
floating-rate notes that are redeemable prior to maturity at the option of
the noteholder. These notes contain certain provisions that effectively
enable noteholders to put these notes back to the Company and, therefore,
are reflected in the table at the date such notes first become redeemable.
The final maturity dates of these notes are during fiscal 2010-2011.
(3) Includes 383 Madison Avenue Headquarters in New York City.
(4) See Note 11, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
Commitments
-----------
The Company has commitments(1) under a variety of commercial arrangements. At
May 31, 2007 the Company's commitments associated with lending and financing,
private equity-related investments and partnerships, outstanding letters of
credit, underwriting and other commercial commitments summarized by period of
expiration were as follows:
Amount of Commitment Expiration Per Period
----------------------------------------------------------------------
Commitments
with no
Remaining Fiscal Fiscal stated
(in millions) Fiscal 2007 2008- 2009 2010- 2011 Thereafter Maturity Total
-----------------------------------------------------------------------------------------------------------
Lending-related commitments:
Investment-grade (2) $ 445 $ 925 $ 1,933 $ 710 $ - 4,013
Non-investment-grade(2) 359 311 765 882 12 2,329
Contingent commitments(2) 2,878 17,286 - - 623 20,787
Commitments to invest in private
equity-related investments
and partnerships (3) - - - - 654 654
Underwriting commitments 1,291 - - - - 1,291
Commercial and residential
loans 6,437 1,498 41 7 - 7,983
Letters of credit 4,012 5 35 - - 4,052
Other commercial commitments 44 163 - - - 207
-----------------------------------------------------------------------------------------------------------
(1) See Note 11, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(2) In order to mitigate the exposure to investment-grade,
non-investment-grade and contingent borrowings the Company entered into
credit default swaps approximating $680.8 million, $160.2 million and $1.2
billion respectively, in notional value, at May 31, 2007.
(3) These commitments will be funded, if called, through the end of the
respective investment periods, the longest of such periods ending in 2017.
53
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OFF-BALANCE-SHEET ARRANGEMENTS
In the normal course of business, the Company enters into arrangements with
special purpose entities ("SPEs"), also known as variable interest entities
("VIEs"). SPEs are corporations, trusts or partnerships that are established for
a limited purpose. SPEs, by their nature, are generally not controlled by their
equity owners, as the establishing documents govern all material decisions. The
Company's primary involvement with SPEs relates to securitization transactions
in which transferred assets, including commercial and residential mortgages,
consumer receivables, securities and other financial assets are sold to an SPE
and repackaged into securities or similar beneficial interests. SPEs may also be
used to create securities with a unique risk profile desired by investors and as
a means of intermediating financial risk. The Company, in the normal course of
business, may establish SPEs, sell assets to SPEs, underwrite, distribute and
make a market in securities or other beneficial interests issued by SPEs,
transact derivatives with SPEs, own securities or other beneficial interests,
including residuals, in SPEs, and provide liquidity or other guarantees for
SPEs.
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities--a Replacement of FASB
Statement No. 125," to account for securitizations and other transfers of
financial assets. In accordance with SFAS No. 140, the Company accounts for
transfers of financial assets as sales provided that control has been
relinquished. Control is deemed to be relinquished only when all of the
following conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee is a
Qualifying Special Purpose Entity ("QSPE") or has the right to pledge or
exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. Therefore, the Company
derecognizes financial assets transferred in securitizations, provided that such
transfer meets all of these criteria. See Note 4, "Transfers of Financial Assets
and Liabilities," in the Notes to Condensed Consolidated Financial Statements
for a more complete discussion of the Company's securitization activities.
The Company regularly creates or transacts with entities that may be VIEs. These
entities are an essential part of its securitization, asset management and
structured finance businesses. In addition, the Company purchases and sells
instruments that may be variable interests. The Company adopted FIN No. 46 (R)
for its variable interests in fiscal 2004. The Company consolidates those VIEs
in which the Company is the primary beneficiary. See Note 5, "Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to Condensed
Consolidated Financial Statements for a complete discussion of the consolidation
of VIEs.
The majority of the SPEs that the Company sponsors or transacts with are QSPEs,
which the Company does not consolidate in accordance with this guidance. QSPEs
are entities that have little or no discretionary activities and may only
passively hold assets and distribute cash generated by the assets they hold. The
Company reflects the fair value of its interests in QSPEs on its balance sheet
but does not recognize the assets or liabilities of QSPEs. QSPEs are employed
extensively in the Company's mortgage and asset securitization business.
Certain other SPEs do not meet the requirements of a QSPE, because their
activities are not sufficiently limited or they have entered into certain
non-qualifying transactions. The Company follows the criteria in FIN No. 46 (R)
in determining whether it should consolidate such entities. These SPEs are
commonly employed in collateralized debt obligation transactions where portfolio
managers require the ability to buy and sell assets or in synthetic credit
transactions.
In addition to the above, in the ordinary course of business the Company issues
various guarantees to counterparties in connection with certain derivatives,
leasing, securitization and other transactions. See Note 12, "Guarantees," in
the Notes to Condensed Consolidated Financial Statements for a complete
discussion on guarantees.
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Some derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
54
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into offsetting
transactions that may include over-the-counter derivative contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to offset proprietary market-making and trading activities. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate market
risks associated with holding dealer inventories or in connection with
arbitrage-related trading activities. The Company also utilizes interest rate
and currency swaps, futures contracts and U.S. Treasury positions to hedge
certain debt issuances as part of its asset and liability management.
To measure derivative activity, notional or contract amounts are frequently
used. Notional/contract amounts are used to calculate contractual cash flows to
be exchanged and are generally not actually paid or received, with the exception
of currency swaps, foreign exchange forwards and mortgage-backed securities
forwards. The notional/contract amounts of financial instruments that give rise
to off-balance-sheet market risk are indicative only to the extent of
involvement in the particular class of financial instruments and are not
necessarily an indication of overall market risk.
As of May 31, 2007 and November 30, 2006, the Company had notional/contract
amounts of approximately $10.38 trillion and $8.74 trillion, respectively, of
derivative financial instruments, of which $1.57 trillion and $1.25 trillion,
respectively, were listed futures and option contracts. The aggregate
notional/contract value of derivative contracts is a reflection of the level of
activity and does not represent the amounts that are recorded in the Condensed
Consolidated Statements of Financial Condition. The Company's derivative
financial instruments outstanding, which either are used to offset trading
positions, modify the interest rate characteristics of its long- and short-term
debt, or are part of its derivative dealer activities, are marked to fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 4.2 years and 4.1 years at May 31, 2007 and November 30, 2006,
respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of May 31, 2007 were as follows:
Less Than One to Three to Greater Than
(in billions) One Year Three Years Five Years Five Years Total
-----------------------------------------------------------------------------------------------------
Swap agreements, including
options, swaptions, caps,
collars and floors 2,023.2 $ 1,843.8 $ 1,775.3 $ 2,535.9 $ 8,178.2
Futures contracts 498.3 405.4 30.9 0.1 934.7
Forward contracts 199.7 - - - 199.7
Options held 418.0 123.0 3.1 1.0 545.1
Options written 410.6 102.7 2.9 1.1 517.3
-----------------------------------------------------------------------------------------------------
Total $ 3,549.8 $ 2,474.9 $ 1,812.2 $ 2,538.1 $ 10,375.0
=====================================================================================================
Percent of total 34.2% 23.9% 17.4% 24.5% 100.0%
=====================================================================================================
CRITICAL ACCOUNTING POLICIES
The Condensed Consolidated Financial Statements of the Company are prepared in
conformity with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions that could materially affect reported amounts in the financial
statements (see Note 1, "Summary of Significant Accounting Policies," in the
Notes to Condensed Consolidated Financial Statements). Critical accounting
policies are those policies that are the most important to the financial
statements and/or those that require significant management judgment related to
matters that are uncertain.
Valuation of Financial Instruments
The Company has identified the valuation of financial instruments as a critical
accounting policy due to the complex nature of certain of its products, the
degree of judgment required to appropriately value these products and the
pervasive impact of such valuation on the financial condition and earnings of
the Company.
The Company adopted SFAS No. 157, "Fair Value Measurements," in the first
quarter of 2007. SFAS No. 157 applies to all financial instruments that are
being measured and reported on a fair value basis. This includes those items
reported in "Financial instruments owned" and "Financial instruments sold, but
not yet purchased" as well as other assets and liabilities that are reported at
fair value.
55
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
As defined in SFAS No. 157, fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. In determining fair value the
Company uses various methods including market, income and cost approaches. Based
on these approaches, the Company often utilizes certain assumptions that market
participants would use in pricing the asset or liability, including assumptions
about risk and or the risks inherent in the inputs to the valuation technique.
These inputs can be readily observable, market corroborated, or generally
unobservable firm inputs. The Company utilizes valuation techniques that
maximize the use of observable inputs and minimize the use of unobservable
inputs. Based on the observability of the inputs used in the valuation
techniques the Company is required to provide the following information
according to the fair value hierarchy. The fair value hierarchy ranks the
quality and reliability of the information used to determine fair values.
Financial assets and liabilities carried at fair value will be classified and
disclosed in one of the following three categories:
Level 1: Inputs based on quoted market prices for identical assets or
liabilities in active markets.
Level 2: Observable market based inputs or unobservable inputs that are
corroborated by market data.
Level 3: Unobservable inputs that are not corroborated by market data.
(1) Financial Instruments Valued Based on Inputs Based on Quoted Market Prices
for Identical Assets or Liabilities in Active Markets
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include U.S. Treasuries, other U.S.
Government and agency securities, as well as certain corporate debt securities.
(2) Financial Instruments Whose Inputs are Observable Market Based or
Unobservable Inputs that are Corroborated By Market Data
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all
these assumptions are observable in the marketplace, can be derived from
observable data or are supported by observable levels at which transactions are
executed in the marketplace. A degree of subjectivity is required to determine
appropriate models or methodologies as well as appropriate underlying
assumptions. This subjectivity makes these valuations inherently less reliable
than quoted market prices. Financial instruments in this category include
sovereign debt, certain corporate equities and corporate debt, certain mortgage
backed securities and non-exchange-traded derivatives such as interest rate
swaps. For an indication of the Company's involvement in derivatives, including
maturity terms, see the table setting forth notional/contract amounts
outstanding in the preceding "Derivative Financial Instruments" section.
(3) Financial Instruments Whose Inputs Used to Determine the Fair Value Is
Estimated Based on Internally Developed Models or Methodologies Utilizing
Significant Assumptions or Other Data That Are Generally Less Readily Observable
from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long dated or unique in nature and
therefore engender considerable judgment by traders and their management who, as
dealers in many of these instruments, have the appropriate knowledge to estimate
data inputs that are less readily observable. For certain instruments,
extrapolation or other methods are applied to observed market or other data to
estimate assumptions that are not observable.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, certain mortgage-backed securities and
residual interests. In addition, the Company has a portfolio of Chapter 13 and
other credit card receivables from individuals. Certain of these high yield
positions have limited price observability. In these instances, fair values are
determined by statistical analysis of historical cash flows, default
probabilities, recovery rates, time value of money and discount rates considered
appropriate given the level of risk in the instrument and associated investor
yield requirements.
56
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company is also engaged in structuring and acting as principal in complex
derivative transactions. Complex derivatives include certain long-dated equity
derivatives, certain credit and municipal derivatives and other exotic
derivative structures. These non-exchange-traded instruments may have immature
or limited markets and, by their nature, involve complex valuation methodologies
and models, which are often refined to correlate with the market risk of these
instruments.
See Note 2, "Financial Instruments" of Notes to Condensed Consolidated Financial
Statements for a description of the financial assets and liabilities carried at
fair value.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers and Risk Management Departments perform analysis of internal
valuations, typically on a monthly basis but often on an intra-month basis as
well. These departments are independent of the trading areas responsible for
valuing the positions. Results of the monthly validation process are reported to
the Mark-to-Market Committee ("MTMC"), which is composed of senior management
from the Risk Management and Controllers Departments. The MTMC is responsible
for ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective. Typical approaches include
valuation comparisons with external sources, comparisons with observed trading,
independent comparisons of key model valuation inputs, independent trade
modeling and a variety of other techniques.
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments. As part of these activities, the Company
originates, structures and invests in merger, acquisition, restructuring and
leveraged capital transactions, including leveraged buyouts. The Company's
principal investments in these transactions are generally made in the form of
equity investments, equity-related investments or subordinated loans and have
not historically required significant levels of capital investment.
Equity interests and securities acquired are reflected in the condensed
consolidated financial statements at fair value, which is often represented as
initial cost until significant transactions or developments indicate that a
change in the carrying value of the securities is appropriate. This represents
the Company's best estimate of exit price as defined by SFAS No. 157. Generally,
the carrying values of these securities will be increased based on company
performance and in those instances where market values are readily ascertainable
by reference to substantial transactions occurring in the marketplace or quoted
market prices. Reductions to the carrying value of these securities are made in
the event that the Company's estimate of net realizable value has declined below
the carrying value. See "Merchant Banking and Private Equity Investments" in
Management's Discussion and Analysis for additional details.
Legal, Regulatory and Tax Contingencies
In the normal course of business, the Company has been named as a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory agencies regarding the Company's
business, certain of which may result in adverse judgments, settlements, fines,
penalties, injunctions or other relief.
Reserves for litigation and regulatory proceedings are generally determined on a
case-by-case basis and represent an estimate of probable losses after
considering, among other factors, the progress of each case, prior experience,
and the experience of others in similar cases, and the opinions and views of
internal and external legal counsel. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, the ultimate resolution, the timing of resolution or
the amount of eventual settlement, fine, penalty or relief, if any.
The Company is subject to the income tax laws of the United States, its states
and municipalities and those of the foreign jurisdictions in which the Company
has significant business operations. These tax laws are complex and subject to
different interpretations by the taxpayer and the relevant governmental taxing
authorities. The Company must make judgments and interpretations about the
application of these inherently complex tax laws when determining the provision
for income taxes and must also make estimates about when in the future certain
items affect taxable income in the various tax jurisdictions.
57
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Disputes over interpretations of the tax laws may be settled with the taxing
authority upon examination or audit. The Company regularly evaluates the
likelihood of assessments in each of the taxing jurisdictions resulting from
current and subsequent years' examinations and tax reserves are established as
appropriate.
The Company establishes reserves for potential losses that may arise out of
litigation, regulatory proceedings and tax audits to the extent that such losses
are probable and can be estimated, in accordance with SFAS No. 5, "Accounting
for Contingencies." Once established, reserves are adjusted as additional
information becomes available or when an event requiring a change to the
reserves occurs. Significant judgment is required in making these estimates and
the ultimate resolution may differ materially from the amounts reserved.
ACCOUNTING AND REPORTING DEVELOPMENTS
In July 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty
in Income Taxes--an interpretation of FASB Statement No. 109" ("FIN No. 48").
FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized
in an enterprise's financial statements in accordance with SFAS No. 109. FIN No.
48 prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN No. 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. The Company will adopt the provisions of
FIN No. 48 beginning in the first quarter of 2008. The Company is currently
evaluating the impact, if any, the adoption of FIN No. 48 may have on the
Condensed Consolidated Financial Statements of the Company.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities." SFAS No. 159 permits entities to
elect to measure financial assets and liabilities (except for those that are
specifically scoped out of the Statement) at fair value. The election to measure
a financial asset or liability at fair value can be made on an
instrument-by-instrument basis and is irrevocable. The difference between the
carrying value and the fair value at the election date is recorded as a
transition adjustment to opening retained earnings. Subsequent changes in fair
value are recognized in earnings. The Company will adopt SFAS No. 159 effective
December 1, 2007. The Company does not expect the adoption of SFAS No. 159 to
have a material impact on the Condensed Consolidated Financial Statements of the
Company.
In April 2007, the FASB issued a Staff Position ("FSP") FIN No. 39-1, "Amendment
of FASB Interpretation No. 39." FSP FIN No. 39-1 defines "right of setoff" and
specifies what conditions must be met for a derivative contract to qualify for
this right of setoff. It also addresses the applicability of a right of setoff
to derivative instruments and clarifies the circumstances in which it is
appropriate to offset amounts recognized for those instruments in the statement
of financial position. In addition, this FSP permits offsetting of fair value
amounts recognized for multiple derivative instruments executed with the same
counterparty under a master netting arrangement and fair value amounts
recognized for the right to reclaim cash collateral (a receivable) or the
obligation to return cash collateral (a payable) arising from the same master
netting arrangement as the derivative instruments. The provisions of this FSP
are consistent with the Company's current accounting practice. This
interpretation is effective for fiscal years beginning after November 15, 2007,
with early application permitted. The adoption of FSP FIN No. 39-1 will not have
a material impact on the Condensed Consolidated Financial Statements of the
Company.
In May 2007, the FASB issued FSP FIN No. 46(R)-7, "Application of FASB
Interpretation No. 46(R) to Investment Companies." FSP FIN No. 46(R)-7 amends
the scope of the exception to FIN No. 46(R) to state that investments accounted
for at fair value in accordance with the specialized accounting guidance in the
American Institute of Certified Public Accountants ("AICPA") Audit and
Accounting Guide, Investment Companies, are not subject to consolidation under
FIN No. 46(R). This interpretation is effective for fiscal years beginning on or
after December 15, 2007. Certain consolidated subsidiaries currently apply the
accounting guidance in the AICPA Audit and Accounting Guide, Investment
Companies. The Company is currently evaluating the impact, if any, that the
adoption of this interpretation will have on the Condensed Consolidated
Financial Statements of the Company.
58
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In June 2007, the Accounting Standards Executive Committee of the AICPA issued
Statement of Position ("SOP") 07-1, "Clarification of the Scope of the Audit
and Accounting Guide Investment Companies and Accounting by Parent Companies and
Equity Method Investors for Investments in Investment Companies." This SOP
provides guidance for determining whether an entity is within the scope of the
AICPA Audit and Accounting Guide Investment Companies (the "Guide").
Additionally, it provides guidance as to whether a parent company or an equity
method investor can apply the specialized industry accounting principles of the
Guide (referred to as investment company accounting). This SOP is effective for
fiscal years beginning on or after December 15, 2007, with early application
encouraged. The Company is currently evaluating the impact, if any, the adoption
of SOP 07-1 may have on the Condensed Consolidated Financial Statements of the
Company.
EFFECTS OF INFLATION
The Company's assets are primarily recorded at their current market value and,
to a large extent, are liquid in nature. The rate of inflation affects the
Company's expenses, such as employee compensation, office leasing costs,
information technology and communications charges, which may not be readily
recoverable in the price of services offered by the Company. In addition, to the
extent that inflation causes interest rates to rise and has other adverse
effects on the securities markets and on the value of securities held in
inventory, it may adversely affect the Company's financial position and results
of operations.
For a description of the Company's risk management policies, including a
discussion of the Company's primary market risk exposures, which include
interest rate risk, foreign exchange rate risk, equity price risk and commodity
price risk, as well as a discussion of the Company's credit risk and a
discussion of how those exposures are managed, refer to the Company's Annual
Report on Form 10-K for the fiscal year ended November 30, 2006.
59
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Value-at-Risk
An estimation of potential losses that could arise from changes in market
conditions is typically accomplished through the use of statistical models known
as value-at-risk ("VaR") that seek to predict risk of loss based on historical
and/or market-implied price and volatility patterns. VaR estimates the
probability of the value of a financial instrument rising above or falling below
a specified amount. The calculation uses the simulated changes in value of the
market risk-sensitive financial instruments to estimate the amount of change in
the current value that could occur at a specified probability level.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk,
and commodity risk), due to the benefit of diversification among the risks.
Diversification benefit equals the difference between aggregate VaR and the sum
of the VaRs for the four risk categories. This benefit arises because the
simulated one-day losses for each of the four primary market risk categories
occur on different days and because of general diversification benefits
introduced when risk is measured across a larger set of specific risk factors
than exist in the respective categories; similar diversification benefits also
are taken into account across risk factors within each category. The following
table illustrates the VaR for each component of market risk as of May 31, 2007,
February 28, 2007, November 30, 2006 and August 31, 2006.
February November
May 31, 28, 30, August 31,
(in millions) 2007 2007 2006 2006
----------------------------------------------------------------------------
MARKET RISK
Interest rate $ 30.5 $ 27.6 $ 29.9 $ 37.7
Currency 2.5 1.3 0.8 1.4
Equity 4.8 6.9 3.0 3.9
Commodity/energy 2.4 1.0 0.0 0.0
Diversification
benefit (11.5) (8.9) (4.9) (9.1)
----------------------------------------------------------------------------
Aggregate VaR $ 28.7 $ 27.9 $ 28.8 $ 33.9
============================================================================
60
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during the quarters ended May 31, 2007 and
February 28, 2007:
Quarter Ended February 28,
Quarter Ended May 31, 2007 2007
--------------------------------------------------------------------------------------------
(in millions) High Low Average High Low Average
--------------------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 33.9 $ 24.3 $ 29.0 $ 35.9 $ 22.8 $ 27.7
Currency 3.4 0.0 1.2 2.7 0.0 0.9
Equity 7.6 4.4 6.4 12.2 1.6 6.4
Commodity/Energy 3.0 0.6 1.5 1.8 0.1 1.0
Aggregate VaR 33.3 22.7 27.7 31.6 22.8 27.2
--------------------------------------------------------------------------------------------
Aggregate average VaR increased slightly to $27.7 million for the 2007 quarter
from $27.2 for the quarter ended February 28, 2007. The increase was primarily
due to higher levels of exposure to interest rates and commodities.
The Company utilizes a wide variety of market risk management methods, including
trading limits; marking all positions to market on a daily basis; daily profit
and loss statements; position reports; daily risk highlight reports; aged
inventory position reports; and independent verification of inventory pricing.
Additionally, management of each trading department reports positions, profits
and losses and notable trading strategies to the Risk Committee on a weekly
basis. The Company believes that these procedures, which stress timely
communication between traders, trading department management and senior
management, are the most important elements of the risk management process.
Stress testing (also referred to as scenario analysis) measures the risk of loss
over a variety of extreme market conditions that are defined in advance. Stress
testing is a key methodology used in the management of market risk as well as
counterparty credit risk (see "Credit Risk"). Stress tests are calculated at the
firmwide level for particular trading books, customer accounts and individual
positions. Stress tests are performed on a regular basis as well as on an ad hoc
basis, as deemed appropriate. The ongoing evaluation process of trading risks as
well as the consideration of new trading positions commonly incorporates an ad
hoc discussion of "what-if" stressed market conditions and their impact on
profitability. This analysis varies in its degree of formality based on the
judgment of trading department management, risk management and senior managers.
While the Company recognizes that no methodology can perfectly predict future
market conditions, it believes that these tools are an important supplement to
the Company's risk management process. The Company expects to continue to
develop and refine its formal stress testing methodologies.
61
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The following chart represents a summary of the daily principal transactions
revenues and reflects a combination of trading revenues, net interest revenues
for certain trading areas and other revenues for the quarters ended May 31, 2007
and 2006. The chart represents a historical summary of the results generated by
the Company's trading activities as opposed to the probability approach used by
the VaR model. The average daily trading profit was $19.1 million and $23.3
million for the quarters ended May 31, 2007 and 2006, respectively. There were 2
daily trading losses for the quarter ended May 31, 2007 and 4 daily trading
losses for the quarter ended May 31, 2006. Daily trading losses never exceeded
the reported average aggregate VaR amounts during the fiscal quarters ended May
31, 2007 and 2006. The frequency distribution of the Company's daily net trading
revenues reflects the Company's historical ability to manage its exposure to
market risk and the diversified nature of its trading activities. Market
conditions were favorable for the Company's trading activity in both its
quarters ending May 31, 2007 and 2006. Hedging strategies were generally
effective as established trading relationships remained substantially intact and
volatility tended to be lower than historical norms. No guarantee can be given
regarding future net trading revenues or future earnings volatility. However,
the Company believes that these results are indicative of its commitment to the
management of market trading risk.
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarters Ended May 31, 2007 and May 31, 2006
[BAR CHART - REPRESENTED BY THE PLOT POINTS BELOW]
(10)+ (10)-(5) (5)-0 0-5 5-10 10-15 15-20 20-25 25-30 30-35 35-40 40+
1 1 5 11 6 18 9 7 3 1 2 2007
4 2 4 6 14 13 9 5 2 5 2006
62
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Credit Risk
The Company measures its actual credit exposure (the replacement cost of
counterparty contracts) on a daily basis. Master netting agreements, collateral
and credit insurance are used to mitigate counterparty credit risk. The credit
exposures reflect these risk-reducing features to the extent they are legally
enforceable. The Company's net replacement cost of derivative contracts in a
gain position at May 31, 2007 and November 30, 2006 approximated $5.50 billion
and $4.99 billion, respectively. Exchange-traded financial instruments, which
typically are guaranteed by a highly rated clearing organization, have margin
requirements that substantially mitigate the risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of May 31, 2007:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Percentage
of
Exposure,
Exposure, Net Net
Collateral of Collateral of
Rating (2) Exposure (3) (4) Collateral
--------------------------------------------------------------------------------
AAA $ 1,158 $ 26 $ 1,138 21%
AA 6,924 4,676 2,306 42%
A 3,363 2,116 1,370 25%
BBB 514 362 259 5%
BB and lower 1,682 2,958 351 6%
Non-rated 90 100 77 1%
--------------------------------------------------------------------------------
(1) Excluded are covered transactions structured to ensure that the
market values of collateral will at all times equal or exceed the
related exposures. The net exposure for these transactions will,
under all circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Company's
Credit Department, converted to rating agency equivalents.
(3) For lower-rated counterparties, the Company generally receives
collateral in excess of the current market value of derivative
contracts.
(4) In calculating exposure net of collateral, collateral amounts are
limited to the amount of current exposure for each counterparty.
Excess collateral is not applied to reduce exposure because such
excess in one counterparty portfolio cannot be applied to deficient
collateral in a different counterparty portfolio.
63
Item 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Exchange Act, the Company's management,
including the Company's Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of its disclosure controls and procedures as of the
end of the period covered by this quarterly report. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer have concluded that the
Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under
the Exchange Act) were effective as of the end of the period covered by this
quarterly report (i) to ensure that information required to be disclosed by the
company in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported, within the time periods specified
in the SEC's rules and forms and (ii) to ensure that information required to be
disclosed by the Company in the reports that the Company submits under the
Exchange Act is accumulated and communicated to the Company's management,
including the Company's principal executive and principal financial officers, or
persons performing similar functions, as appropriate, to allow timely decisions
regarding required disclosure. As required by Rule 13a-15(d) under the Exchange
Act, the Company's management, including the Company's Chief Executive Officer
and Chief Financial Officer, has evaluated the Company's internal control over
financial reporting to determine whether any changes occurred during the quarter
covered by this quarterly report that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting. Based on that evaluation, there have been no such changes during the
quarter covered by this quarterly report.
64
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
In the normal course of business, the Company has been named a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory organizations regarding the
Company's business. Certain of the foregoing could result in adverse judgments,
settlements, fines, penalties or other relief.
Because litigation is inherently unpredictable, particularly in cases where
claimants seek substantial or indeterminate damages or where investigations and
proceedings are in the early stages, the Company cannot predict with certainty
the loss or range of loss related to such matters, how such matters will be
resolved, when they will be ultimately resolved, or what the eventual
settlement, fine, penalty or other relief might be. Consequently, the Company
cannot estimate losses or ranges of losses for matters where there is only a
reasonable possibility that a loss may have been incurred. Although the ultimate
outcome of these matters cannot be ascertained at this time, it is the opinion
of management, that the resolution of the foregoing matters will not have a
material adverse effect on the financial condition of the Company, taken as a
whole; such resolution may, however, have a material effect on the operating
results in any future period, depending on the level of income for such period.
The Company has provided reserves for such matters in accordance with Statement
of Financial Accounting Standards No. 5, "Accounting for Contingencies". The
ultimate resolution may differ from the amounts reserved.
Certain legal proceedings in which the Company is involved are discussed in Note
17 to the consolidated financial statements included in the Company's 2006
Financial Report; Part I, Item 3, of the Company's Annual Report on Form 10-K
for the fiscal year ended November 30, 2006 and in Note 11 to the condensed
consolidated financial statements included herein. The following discussion is
limited to recent developments concerning our legal proceedings and should be
read in conjunction with those earlier Reports.
Municipal Bond Offering Matters: As previously reported in the Company's Form
10-K for fiscal year ended November 30, 2006 ("Form 10-K"), Bear Stearns was the
subject of a formal investigation by the Chicago office of the Securities and
Exchange Commission ("SEC") into its municipal bond offering practices. By
letter dated June 4, 2007, the SEC advised Bear Stearns that this investigation
has been completed and that the SEC Staff does not intend to recommend any
enforcement action by the SEC against Bear Stearns.
IPO Allocation Securities and Antitrust Litigations: As previously reported in
the Company's Form 10-K, Bear Stearns is a named defendant, along with nine
other financial services firms, in an antitrust complaint filed on behalf of a
putative class of purchasers who, either in IPOs or in the aftermarket,
purchased technology-related securities during the period of March 1997 to
December 2000. In November 2003, the district court had granted defendants'
motion to dismiss all claims asserted in this action. The plaintiffs appealed
that decision to the Second Circuit Court of Appeals and on September 28, 2005,
the Court of Appeals vacated the dismissal and remanded this matter to the lower
court for further proceedings. On or around December 7, 2006, the U.S. Supreme
Court granted defendants' petition for certiorari to appeal the decision issued
by the Second Circuit Court of Appeals. On June 18, 2007, the U.S. Supreme Court
reversed the Second Circuit Court of Appeals' decision.
65
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The table below sets forth the information with respect to purchases made by the
Company of the Company's common stock during the second quarter of fiscal 2007:
Approximate Dollar
Total Number of Value of Shares
Shares that
Average Purchased as Part of May Yet Be
Total Number Price Paid Publicly Announced Purchased
of Shares per Plans or Programs Under the Plans or
Period Purchased Share (1) Programs (1)
----------------------- ---------------- ------------- --------------------- --------------------
3/1/07 - 3/31/07 788,663 $ 148.61 788,663 $ 1,625,566,144
4/1/07 - 4/30/07 648,440 152.47 648,440 1,526,699,129
5/1/07 - 5/31/07 742,079 152.19 742,079 1,413,764,931
---------------- ---------------------
Total 2,179,182 150.98 2,179,182
---------------- ---------------------
(1) On December 13, 2006, the Board of Directors of the Company approved an
amendment to the Stock Repurchase Program ("Repurchase Program") to replenish
the previous authorizations to allow the Company to purchase up to $2.0 billion
of common stock in fiscal 2007 and beyond. During the quarter ended May 31,
2007, the Company purchased under the current authorization a total of 1,969,585
shares at a cost of approximately of $297.3 million. Approximately $1.28 billion
was available to be purchased under the current authorization as of May 31,
2007. The Company expects to utilize the repurchase authorization to offset the
dilutive impact of annual share awards. The Company may, depending upon price
and other factors, repurchase additional shares in excess of that required for
annual share awards. During the quarter ended May 31, 2007, the Company also
purchased a total of 209,597 shares of its common stock at a total cost of $31.8
million pursuant to a $200 million CAP Plan Earnings Purchase Authorization,
which was approved by the Compensation Committee of the Board of Directors of
the Company on December 12, 2006.
66
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of the Company held on April 18, 2007 (the "Annual
Meeting"), the stockholders of the Company approved an amendment to the
Company's Stock Award Plan to increase the number of authorized shares of Common
Stock available for the grant of options from 40,000,000 shares to 45,000,000
shares. The stockholders of the Company also approved amendments to the
Company's Restricted Stock Unit ("RSU") Plan ("RSU Plan") to: (i) increase the
number of authorized shares of Common Stock available for issuance or delivery
in connection with awards of RSUs under the RSU Plan from 15,000,000 to
25,000,000; and (ii) provide that participants will have the right to give
voting and tender instructions with respect to any shares of Common Stock held
in trust to satisfy obligations under the RSU Plan. In addition, the
stockholders of the Company approved amendments to the Capital Accumulation Plan
for Senior Managing Directors ("CAP Plan") to: (i) modify the definition of
"Income Per Share" and (ii) provide participants with the right to give voting
and tender instructions with respect to any shares of Common Stock, including
prior vesting, that are held in trust to satisfy obligations under the CAP Plan.
The 2007 Performance Compensation Plan was also approved by the stockholders at
the Annual Meeting. In addition, at the Annual Meeting the stockholders of the
Company elected thirteen directors to serve until the next Annual Meeting of
Stockholders or until successors are duly elected and qualified or until earlier
resignation or removal. Additionally, the stockholders of the Company ratified
the appointment of Deloitte & Touche LLP as the independent auditors for the
fiscal year ending November 30, 2007. The stockholders of the Company did not
approve the proposal regarding a Pay-For-Superior-Performance Standard at the
Annual Meeting.
The affirmative vote of a majority of the shares of common stock represented at
the Annual Meeting and entitled to vote was required for the approval of the
amendments to the Stock Award Plan, RSU Plan, CAP Plan, approval of the 2007
Performance Compensation Plan and ratification of the independent auditors, as
well as the disapproval of the proposal regarding a Pay-For-Superior-Performance
Standard, while the affirmative vote of a plurality of the votes cast by holders
of shares of common stock was required to elect the directors.
With respect to the approval of the amendments to the Stock Award Plan, RSU
Plan, CAP Plan, approval of the 2007 Performance Compensation Plan, ratification
of the independent auditors, and disapproval of the stockholder proposal
regarding a Pay-For-Superior-Performance Standard, set forth below is
information on the results of the votes cast at the Annual Meeting.
Broker
For Against Abstained Non-Votes
--- ------- --------- ----------
Amendment to the Stock Award Plan 44,457,585 42,316,486 822,038 22,230,978
Amendments to the Restricted Stock Unit Plan 45,788,121 40,981,899 826,089 22,230,978
Amendments to the Capital Accumulation Plan for Senior
Managing Directors 82,618,639 4,146,242 831,228 22,230,978
Approval of the 2007 Performance Compensation Plan 105,401,050 3,517,173 908,864 N/A
Ratification of the selection of independent auditors 107,681,101 1,425,198 720,788 N/A
Stockholder proposal regarding a Pay-For-Superior-Performance
Standard 27,720,809 58,899,926 972,037 22,234,315
67
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
With respect to the election of directors, set forth below is information with
respect to the nominees elected as directors of the Company at the Annual
Meeting and the votes cast for and withheld with respect to each such nominee.
Nominees For Withheld
------------------------- ------------------ --------------------
James E. Cayne 107,989,432 1,837,655
Henry S. Bienen 108,888,405 938,682
Carl D. Glickman 103,447,977 6,379,110
Michael Goldstein 97,943,263 11,883,824
Alan C. Greenberg 107,727,869 2,099,218
Donald J. Harrington 107,227,125 2,599,962
Frank T. Nickell 107,021,669 2,805,418
Paul A. Novelly 108,903,841 923,246
Frederic V. Salerno 97,093,265 12,733,822
Alan D. Schwartz 107,775,365 2,051,722
Warren J. Spector 107,766,751 2,060,336
Vincent Tese 99,336,619 10,490,468
Wesley S. Williams Jr. 108,919,496 907,591
---------------------------------------------------------------------------
68
Item 6. EXHIBITS
Exhibits
(10.1) Stock Award Plan, amended and restated as of April
18, 2007
(10.2) Restricted Stock Unit Plan, amended and restated as
of April 18, 2007
(10.3) Capital Accumulation Plan for Senior Managing
Directors, amended and restated as of April 18, 2007
(10.4) 2007 Performance Compensation Plan, dated as of
April 18, 2007 (incorporated by reference to Exhibit
I to the registrant's Definitive Proxy Statement for
its 2007 Annual Meeting of Stockholders)
(11) Computation of Per Share Earnings. (The calculation
of per share earnings is in Note 9, "Earnings Per
Share," of Notes to Condensed Consolidated Financial
Statements (Earnings Per Share) and is omitted here
in accordance with Section (b) (11) of Item 601 of
Regulation S-K)
(12) Computation of Ratio of Earnings to Fixed Charges
and to Combined Fixed Charges and Preferred Stock
Dividends
(15) Letter re: Unaudited Interim Financial Information
(31.1) Certification of Chief Executive Officer Pursuant to
Rule 13a-14(a) or 15d -14(a) of the Securities
Exchange Act of 1934, as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant to
Rule 13a-14(a) or 15d-14(a) of the Securities
Exchange Act of 1934, as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant to
18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
(32.2) Certification of Chief Financial Officer Pursuant to
18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
69
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
The Bear Stearns Companies Inc.
-------------------------------
(Registrant)
Date: July 10, 2007 By: /s/ Jeffrey M. Farber
--------------------------------
Jeffrey M. Farber
Senior Vice President - Finance,
Controller
(Principal Accounting Officer)
70
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Exhibit No. Description Page
----------- ----------- ----
(10.1) Stock Award Plan, amended and restated as of April
18, 2007
(10.2) Restricted Stock Unit Plan, amended and restated as
of April 18, 2007
(10.3) Capital Accumulation Plan for Senior Managing
Directors, amended and restated as of April 18, 2007
(10.4) 2007 Performance Compensation Plan, dated as of
April 18, 2007 (incorporated by reference to Exhibit
I to the registrant's Definitive Proxy Statement for
its 2007 Annual Meeting of Stockholders)
(12) Computation of Ratio of Earnings to Fixed Charges 73
and to Combined Fixed Charges and Preferred Stock
Dividends
(15) Letter re: Unaudited Interim Financial Information 74
(31.1) Certification of Chief Executive Officer Pursuant to 76
Rule 13a-14(a) or 15d -14(a) of the Securities
Exchange Act of 1934, as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant to 77
Rule 13a-14(a) or 15d -14(a) of the Securities
Exchange Act of 1934, as Adopted Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant to 78
18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
(32.2) Certification of Chief Financial Officer Pursuant to 79
18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
71